Value investing involves determining the intrinsic value — the true, inherent worth of an asset — and buying it at a level that represents a substantial discount to that price.
The gap between a stock’s intrinsic value and the price it is currently selling for is known as the margin of safety.
The greater the margin of safety, the more an investor’s projections can be off while still profitably gaining from an investment in the shares of the company being evaluated.
It can be helpful to ensure you understand what value investing is and is not. It is not searching for stocks with low price-to-earnings ratios and blindly buying the stocks that make that first cut. Instead, value investors employ a series of metrics and ratios to help them determine a stock’s intrinsic value and a sufficient margin of safety.
Value investing in stocks often means looking for mispriced shares in out-of-the-way places. This can include looking at companies in out-of-favor sectors, businesses in frowned-upon industries, companies that are going through some type of scandal, or stocks currently enduring a bear market. Unpopular sectors and companies are often treasure troves for the successful value investor, requiring the possession of both a long-term approach and a contrarian mindset. Regardless of where the investments come from, though, value investing is the art and science of identifying stocks priced below their actual worth.
Successful value investing exercise patience and hold during lean times. Taking just one example, in early 2015, American Express shareholders learned that AmEx lost its exclusive credit-card deal with Costco Wholesale locations. In the following months, Amex lost almost 50% of its market-cap value. Yet far from being a moment to panic, savvy investors might have seen an opportunity to buy AmEx for outsized gains. Within three years of its lowest point, American Express had almost doubled and reached new all-time highs.
Selling at lows while negative sentiment is at its highest will guarantee frustration and permanent loss of capital. It can be hard to wait while your thesis plays out, but patience is absolutely necessary for value investors who want to beat the market.
Of course, value investing is more than a waiting game. Investors must remain diligent in staying up to date on a company to ensure their thesis is proceeding as planned. This means paying attention to the company’s business performance — not its stock price.
The Big 5 Numbers
Phil Town, founder and CEO of Rule #1 Investing, says there are “the big 5 numbers” in value investing.
The Big 5 numbers are:
- Return on Invested Capital (ROIC)
- Equity (Book Value) Growth
- Earnings per Share (EPS) Growth
- Sales (Revenue) Growth
- Cash Growth
All the big 5 numbers will be 10% or greater if the company, and he numbers should be stable or growing over the past 10 years.
The big takeaway
Value investing is not easy. It requires time, focus, discipline, patience and dedication to the craft. It will often mean looking and feeling foolish while you wait for an investment thesis to play out. If this doesn’t sound like it’s for you, investing in passive index funds is a perfectly suitable alternative.
For investors who enjoy the hunt of looking for undervalued assets — and beating the market at its own game — value investing can be richly rewarding in more ways than one. By following this simple guide, investors can be well on their way to understanding how value investing can beat the market.
References:
- https://www.foxbusiness.com/markets/how-to-be-a-successful-value-investor
- https://wp.ruleoneinvesting.com/blog/how-to-invest/value-investing/
- https://valueinvestoracademy.com/i-read-rule-1-by-phil-town-heres-what-i-learned/