Value investing: basic concepts and issues
PS: The following article was something I wrote for a website in 2014. It can’t be found anymore so I’m republishing it here as I thought it might be useful to someone out there.
What is value investing? It is a style of investing in stocks where you buy companies that are fundamentally strong, at less then what they are worth. At its heart, there are only 2 concepts involved.
The first concept underlying value investing is that the future is uncertain. Hence the focus in investing in fundamentally strong companies, as they have a higher probability of coming out ahead of their peers through time.
As a result of the first concept, diversification is also a main cornerstone of value investing as it is still possible for a company or even several companies to fail despite everything good about it. The key to riches for this investment style is that, should a company rise in price, it should rise beyond your wildest imagination (or at least enough to cover the failures).
How do you determine if a company is cheap at its current price? In general, this first involves a careful exploration of the company’s financial statements to determine its strengths and weaknesses. Next, together with understanding the current political, economic, social, technological, environment and legal landscape/trend (PESTEL analysis), you derive an assumption of future performance which can be used to come up with an estimate of the company’s intrinsic price (i.e. what it is really worth). If the current price is lower than the intrinsic price, the company is then considered “cheap”. Among all of this, one also takes into consideration the product, people, culture and relationship that the company have.
(Note: This is just one evaluation framework that is used for organizing data. The point is to look at a company from all angles.)
Sound logical? Unfortunately the above paragraph is flawed in a major way. And a warping of what value investing originally is. Can you tell where is the flaw? Spend some moment to think about it before reading on. Its good exercise.
The key problem is the approach. As I mention above, a key concept in value investing is that the future is uncertain. And…. in trying to determine the intrinsic price, one is essentially predicting the future.
(Note: the basic framework in determining a strong company is the same as finding out the intrinsic price, just that you are aware that you are focusing on the present and not as a leaping board to predict the future. And PESTEL analysis is more applicable in another investment approach called macro investing.)
This is beginning to sound like an impossible problem. How can you determine if a company is cheap if you cannot determine how much it is actually worth? The truth is you do not have to know exactly how much a company is really worth, only that it is fundamentally strong. The key is waiting for situations that cause the prices of good companies to go down or remain low through no fault of their own. And only buy good companies then. (i.e. buy only when there is a divergence between current and intrinsic price)
There is another major concept in value investing called Margin of Safety. It starts with an estimate of intrinsic price. And because one is aware that an estimate is just an estimate, you want to buy companies where the current price is much lower than your estimate to be. This difference is the Margin of Safety. The bigger the difference, the better. It ensures that even if your estimation is too optimistic, you are still buying companies that are lower than what they are really worth.
Now, I would not say that it is an impossible task to derive a good estimate of a company’s intrinsic value. Just that it is a very difficult skill to acquire and prone to many errors. On the bright side for value investors though, it is comparatively much easier to identify situations that causes the current price to diverge from its intrinsic value and profit from it.
Before we move on, lets talk a bit about a company’s present price. In a normal functioning market, it is safe to assume that the current price is very close to the intrinsic price thanks to the wisdom of the crowds (Note that this naturally means that the stock is well followed in a market with diverse participants). In case you have not realise, this also means that when the price of a stock is falling, it is usually falling with good reasons. A low stock price does not equal “cheap to buy”.
So then, some keys to finding stocks at good prices lie in the above paragraph. I leave it up to you to think about it. I’ll point out one of the most obvious situations to find bargain prices though: stock market crashes. A lot of opportunities here as you have stock prices falling in response to external circumstances through no fault of their own. The stock fundamentals remain largely unchanged. The margin of safety is huge as you are helped by both over-reacting humans and herd behaviour where majority of market participants are acting similarly.
Thats it. The basics of value investing. In short, it is about:
- understanding that the future is uncertain, hence diversify
- concentrate on identifying fundamentally strong companies
- being alert to situations that causes price to diverge from what its worth and buy them then
- Get as much of a buffer or Margin of Safety as possible
To end my introduction, let me leave you with some takeaways from Joel Greenblatt (See Hedge fund market wizards):
- Value investing works
- Value investing does not work all the time
- Item 2 is one of the reason why 1 is true
This can be easily explained by thinking this way: when value investing is mainstream, there are many smart value investors looking for a bargain everywhere. As a result, the probability of one finding a bargain gets lower and more difficult as time goes by as the good ones get bought up and increase in price. Hence, for a time, it does not work.
Thankfully, situations will happen to cause value investors to drop out, and value investing becomes viable again. A notable example being the tech boom/bubble in the 90s where the prices are emotionally driven for a long period of time. Many notable value investors did badly or just ordinary during that period of time.