Value investing is a challenging pastime. Buying stocks when the rest of the market is selling requires a unique mindset, but that is not the only quality necessary to be a good value investor. Value investors also need a high level of patience and an inquisitive mind.
Anyone with a brokerage account can buy a stock when the rest of the market is selling. This is not automatically value investing. Buying hoping to make a profit without any knowledge of the underlying business is not investing - it's the same as speculating and gambling, and I see no difference between that and buying overpriced stocks hoping to profit off of momentum.
The most crucial quality value investors must possess is the desire to learn, about everything from companies to sectors and industries. The only way to build a detailed understanding of potential investment opportunities is to do the work. The goal is to research enough to be able to tell whether a falling stock is truly undervalued, or whether it is being sold for good reason.
I believe this is where most value investors fail. I also think it is the main reason why there is a widespread belief that value investing has underperformed the market over the past decade.
Incorrect focus
When analysts usually review the performance of value strategies, they mistakenly focus on simple ratios such as the price-earnings ratio and the price-book ratio. These figures do not tell us if a stock is undervalued. They are just numbers which can be easily manipulated in this day and age.
The price-earnings ratio tells us nothing about the quality of the underlying company's earnings or what it will earn in the future. Meanwhile, the price-book ratio tells us nothing about the quality of the balance sheet, or if the assets or liabilities are worth what the company says they are.
Value investing is only made more difficult by the business environment. The only constant in the world of business is constant change. Companies and sectors are constantly being born and failing. The business environment is continually changing, and the only way businesses can deal with this is to try and stay ahead of the competition.
This is another reason why simple metrics should not be relied on for value investing. A company can look cheap when compared to the book value of its assets, but if these assets are completely unproductive and irrelevant in the 21st century, they are going to be worth significantly less than the stated book value. Of course, they might have a scrap value, but investors will need to complete a detailed due diligence process to understand how much they could be worth in a stressed scenario.
The point is, value investing is not easy, and investors should never make the mistake of believing that it is. It requires detailed analysis on each and every opportunity to understand how the company makes money, where the growth options are and how management has performed in the past and will likely perform in the future.
Finding undervalued investments
The object of value investing is to buy a company for less than it is worth. This simple statement is often misused. The best value investors will not focus on how much a company is worth today but what it will be worth in several years. In other words, the objective of value investing should be to buy a company for less than it will be worth, as concentrating too much on its current net worth will overlook essential factors such as growth or shrinkage in the business.
If a company is worth $10 billion today, but its earnings are falling, its net worth could fall to $9 billion in two years. This is not a great value investment. It can take years for the market to re-rate a business to its intrinsic value, but if the intrinsic value is falling, the market may re-rate the stock to a lower value than the initial purchase price.
On the other hand, if the intrinsic value rises from $10 billion to $11 billion, even if the stock is always trading at a 10% discount to intrinsic value, it will produce a positive return for shareholders.
The challenge facing value investors is to understand the connection between value, intrinsic value and intrinsic value growth. Putting too much emphasis on one of these factors individually may produce undesirable results.
