Value investing is one of the most popular styles of investing. Yet it is also one of the most misunderstood because value investing is not just about buying cheap stocks.
Buying cheap junk is not going to make you money, no matter how cheap the junk is. This is something the founder of value investing, Benjamin Graham, tried to make clear with his simple strategies to help investors find undervalued value stocks.
Three of his 10 criteria for finding undervalued common stocks are:
- Total debt less than book value.
- Current ratio greater than two.
- Total debt less than twice "net current asset value."
Two key concepts
There are two key concepts to value investing. These are: intrinsic value and the margin of safety.
Investors who are new to the sport of value investing often become confused between value and price. What I mean by this is that rather than concentrating on intrinsic value and the margin of safety, novice value investors focus on finding stocks that look cheap. But just because a stock looks cheap, it doesn't necessarily mean that it is trading at a discount to its intrinsic value.
From this perspective, the idea of value investing can be misleading. If you change the name to "stocks trading at a discount to intrinsic value investing," it would be a more accurate reflection of what the strategy is about.
Intrinsic value
Being able to calculate intrinsic value is a fundamentally important part of being a successful value investor. The problem is, many value investors look over this crucial component. They look for shortcuts such as buying stocks just because they look cheap relative to the rest of the market, without considering at the independent financials of each situation.
This is the big drawback with relative valuation. Relative valuation might tell you that a company is undervalued, but what about the rest of the market? If the rest of the market is overvalued, where does that leave you?
Calculating a company's intrinsic value requires a lot of work. What's more, the measure is highly subjective. It requires a lot of work and experience to calculate a value and have confidence that the value is reliable and correct.
There's also the problem that a stock could be undervalued according to your intrinsic value calculation, but it may look expensive compared to the rest of the market. In this case, it is essential to have confidence in your own calculations. The best way to build confidence and durability into your intrinsic value models is with research, experience and multiple angles of attack.
A new approach
Put simply, value investing is an inadequate label for this style of investing. It is a misleading title because it gives the idea that value is a fixed number. It is not. It is quite the opposite. Value is not fixed, and intrinsic value is never going to be an accurate reflection of a company's worth, particularly in auction markets. It takes time and effort to determine the intrinsic value and only then can you be sure that you are buying a stock with a margin of safety.
And when you look at value investing from this perspective, it becomes clear that all investing is value investing. No one says they want to pay more than a company is worth to buy it. Everyone says they want to get a deal and to buy the business for less than it is worth.
So, if you want to become a better investor, rethinking how you approach investing and evaluation might be a good place to start. Just because you think you are a value investor does not mean you have to buy stocks with low price-book ratios. It does not even necessarily mean that you have to avoid stocks with high price-earnings ratios.
As long as your research and evidence shows that a company appears undervalued, and you are confident that you are buying at a deep discount to intrinsic value, you can be a good value investor.
Disclosure: The author owns no share mentioned.
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