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When I was in college, I thought I wanted to be an equity analyst. So, I went and got two degrees in finance, focusing heavily on investments. But what I learned is that I was taught the sexier methods of investing – looking purely at numbers. This is only one part of value investing, which is what makes looking for value stocks so much more difficult. However, the plus side to this is that it can be more rewarding in the long run.
In this article, I’ll examine the value of value investing, so you can start to understand how in-depth and difficult it can be. But if you dedicate the time and energy to learning it, it can pay huge dividends (pun intended).
An important caveat: this article is meant to describe the value of value investing, not teach you everything you need to know to become a true value investor. If you want a deep-dive into the topic, I recommend reading The Intelligent Investor by Benjamin Graham. It’s hands-down one of the best books ever written on investing and describes value investing in great detail, as well as specific tactics and things to look for when choosing a value stock.
What is Value Investing?
Value investing is a type of investing where you focus on a deep analysis of the company as a whole to determine if it’s undervalued or overvalued. The value you’re looking for is the intrinsic value, meaning the company’s overall predisposition for growth.
To be clearer, I’ll describe the opposite approach, which I’d call reactionary investing or just pure speculation. Let’s say that Microsoft is launching a new virtual reality technology that you think will change the game in the tech space, so you buy up a ton of Microsoft stock hoping that it’ll grow.
There’s a chance you’ll win, but there’s also a chance you’ll lose – this is nothing more than speculation. You’re just reacting to market news.
You haven’t analyzed the company, its leadership, its products, its financials, or anything else. Therefore, this is the opposite of value investing.
Think about value investing like a mindset or a philosophy. It takes deep knowledge, patience, and practice. But it’s what has made famous investors like Warren Buffet so successful.
It’s not sexy, but it can be a real game-changer when it comes to your long-term financial prosperity. Let’s now dive into how exactly value investing works.
How Value Investing Works
Value investing focuses on finding a probable margin between what you’d pay for a stock and what you’d earn on that stock as the company grows over time – the margin of safety.
A great way of thinking about the margin of safety is as it relates to shopping. I’ll use shoes as an example.
I used to buy really cheap shoes for work, and they’d wear out very quickly. After about three or four pairs of the same shoes, I decided I should just pay for a more expensive pair. But those wore out quickly, too, and I realized that it was the use I was putting on them (I walk a lot in my shoes).
So, in a sense, I was getting the same value out of both the expensive shoes and cheap shoes. Yet, my margin of safety was much lower with the expensive shoes (e.g., I paid more but they lasted the same amount of time before I needed new ones).
Using my shoe example, a value investing approach would be to find a low-cost, quality shoe that would last the time I needed it to.
It’s the same way of thinking with stocks. If you can find an undervalued stock that you think will grow in value or give you a greater margin of safety than a similar stock that’s more expensive, it gives you a great starting point. But there’s more to value investing than just a silly shoe scenario.
Three Key Principles of Value Investing
As a value investor, you should follow three key principles:
1. Deeply analyze the company
With value investing, you need to focus on more than just market news, sexy products, and numbers you think matter (can we stop obsessing over P/E ratio?). A value investor will look at the long-term business growth of a company, as well as their core principles and values as a business before even considering buying a stock.
What exactly does this mean?
It means that a stock’s value in and of itself isn’t arbitrary. Instead, it directly correlates to the company that’s behind it, and how it performs. Sure, you might see swings up and down with a stock based purely on news, but again, that’s speculation, not value investing.
A good value investor will look at things like the financial structure of a company (e.g., assets, long-term debt), whether or not it pays consistent dividends (e.g., how are they distributing their profits?), and who is actually managing the company (e.g., who is their CEO, CFO, and on their board of directors?). While this won’t tell you everything, it’ll tell you a lot about a company.
Short-term earnings can add some value, but overall, they should be a microcosm of what you’re looking at when picking a stock. Instead, take the big-picture view and understand the history of the company and how it operates as a business.
Taking this approach can also help you find gem companies to invest it. You will probably end up finding a company that isn’t popular, or may even have a bad public reputation, but holds firm to all the other things you’re looking at (e.g., good financials, a great management team), making it a solid investment.
This shouldn’t shock you, but a core tenant of value investing is to make sure you’re diversifying your investments. Don’t put all your eggs in one basket, even if you find a stock that you think is seriously undervalued.
I know this seems like common sense, but I can’t emphasize the importance of this enough with value investing. Value investing will cause you to weed out a significant number of stocks based on very stringent criteria, so diversification might be difficult.
3. Slow and Steady Wins the Race
Remember that value investing isn’t day trading and it’s not speculation. You can make tons of money on those types of strategies, but you can also lose everything. Value investing takes a “slow and steady wins the race” approach, meaning that you should be looking for undervalued stocks that will grow over time.
This also means you need to buy and hold until the value of your investment is realized. This might be frustrating for some, because you may not see big gains for years. The goal here, though, is to focus on modest and consistent returns over time. If this frustrates you, then that’s the first sign that value investing isn’t for you.
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Value Investors Know the Importance of History
I’ll be the first to tell you that past performance isn’t a true indicator of future success when it comes to stocks because things are so unpredictable. But understanding the importance of the history of the markets, and individual companies is critical.
The first reason this is important is so you can mentally and psychologically prepare yourself to weather the storms. Think about the stock market crash of 1929, 2002, and 2008. Those were huge hits. People panicked and sold off their stocks to get into something they felt was safer – and now they’re paying for it.
As a value investor, you have to understand that, over the course of time, the stock market has trended upward and grown steadily. Yes, there are significant ups and downs and there is no guarantee when a rebound will happen, but history tells us that it will.
You won’t be able to predict a crash but understanding the history will help you time it a little better. When you determine that the market is in a stable enough place to invest, you can examine the history of the company you’re looking to invest in.
A great place to start is to review the correlation between a company’s stock price and its earnings throughout the past decade. Factor in things like inflation, so you can see what your real earnings would be over those ten years.
For instance, if you calculated an earning of 6 percent one year, but inflation was about 4 percent, your true earnings would have only been 2 percent. That may not make it a worthwhile investment during that period.
Again, this won’t solve everything, but understanding history will be a key tool in your toolbox of value investing.
Value Investors Know How to Block Out the Noise
If you read The Intelligent Investor, you’ll learn about Mr. Market. I love this analogy because it helps you focus on tuning out the noise of what the stock market is trying to shove in your face.
If you think of the stock market like a person (Mr. Market), you’ll know that it can be moody, grumpy, and have all kinds of emotions. Heck, some days it’s happy and giving you nothing but great news. But spending too much time with this person can cause your own mood and opinions on things to change.
Let’s go back to my example of Microsoft releasing new technology. Let’s say your friend, Mr. Market, calls you up and is super excited about this new technology, telling you it’s going to change the game for technology forever. So you get all ramped up and you look to buy Microsoft stock.
But guess what? Mr. Market has already told the whole neighbourhood the same thing, so everyone is excited. And guess what that is doing to the stock price?
It’s over-inflating it.
But because you trust Mr. Market and you’re so excited, you pay the premium anyway, knowing that it’s going to change technology forever and it doesn’t really matter what you pay now.
This idea is a bit abstract, but if you get it, you’ll understand why value investors (good ones, at least) can ignore Mr. Market and instead focus on facts. Block out the noise – both positive and negative – and make rational decisions. Don’t listen to shows like Mad Money that tell you garbage information and try to capitalize on your emotions.
These things will just trick you into thinking things that probably aren’t true. With today’s environment of smartphones, it’ll be even harder. So you’ll need to train yourself to listen to and read the news, but take it with a grain of salt. And think of it like a moody old man named Mr. Market.
Becoming a Value Investor: Defensive vs. Enterprising
When you start investing like a value investor, it’s important to choose which type of value investor you want to be. In his book, Benjamin Graham defines two types of value investors: defensive and enterprising. I’ll cover both briefly, so you can determine which method fits your style best.
A defensive value investor follows a simpler path than that of an enterprising investor. You still need to do your research, but you can get started with less of a headache.
First, know that defensive investors hate risks, so mitigating these risks can be accomplished by diversifying your investments and choosing a group of “safer” investments as well. A defensive value investor would ideally have a 50/50 split between stocks and bonds.
This might sound crazy, but remember, defensive investors HATE risks. For bonds, choose high-grade bonds (like AAA government debt securities) and for stocks, choose common stocks that give you some type of voting power.
Your common stock portfolio should also be well-diversified. Pick at least ten different companies to invest in and focus on large companies that are well-known and have a long history of success.
A quick way to do this is to look at investment funds (either mutual funds or ETFs) that focus on these types of big-name stocks. Pick the top ten stocks in the fund, or choose ten out of the top 25, and replicate it to start your investment strategy.
Yes, there’s more analysis involved with value investing, but this will at least give you a starting point to getting your portfolio up and running.
Choose an Investment Amount and Frequency, Then Set It to Autopilot
Once you choose your investments and your initial investment amount, the best thing you can do is set it up to invest automatically. Decide how much you can afford to invest each week or month and establish an auto-deposit to your brokerage. You can set up rules that will auto-invest for you, which will allow you to keep investing and stay diversified.
Once you’ve done that, I recommend looking at your portfolio at least once every six months to re-evaluate and rebalance. You can analyze how your stocks are performing and whether or not it’s the right mix for you.
An enterprising investor takes some of the same strategies as a defensive investor but is more aggressive with their approach. Like a defensive investor, you should split up your portfolio between stocks and bonds but place a heavier weight on stocks.
For most enterprising investors, I think a 90/10 (stocks to bonds) split is more than appropriate. You may want to go more or less based on your risk tolerance, but having 90% of your portfolio in well-chosen stocks, with 10% dedicated to high-grade bonds to me is a great strategy.
Where it gets a little riskier is the type of stocks you invest in. You should definitely focus on common stocks and big-name companies like defensive investors do, but you should also dedicate about 10 percent (no more than this though) of your portfolio to riskier stocks – ones that are high-risk/high-reward.
This might mean finding the next Apple, Amazon, or Google, doing research to make sure it checks your criteria, and throwing a “what the heck” allotment of money into it, knowing the risk is higher (but so are the rewards).
Remember, this doesn’t mean listening to Mr. Market and being irrational. You’re still making rational decisions, but you’re taking on a riskier investment than you normally would.
Because a good enterprising value investor will ignore the market ups and downs, he or she will know when to properly buy and sell. This means buying when the market is down and selling when the market is high.
For some, this can be hard (see my note above about the market crashes). When a market is down, psychologically you might think it’ll drop even further. But this is listening to Mr. Market. Ignore it and make a rational decision to buy more when the market is down.
Same thing when the market is up. You might think that it can keep going higher and higher – and it might – but you have to be a smart investor and sell when you feel the time is right.
Finally, an enterprising investor looks for amazing deals. Meaning, they can find stocks that are seriously undervalued and know when to buy them. I recommend testing your ability to invest for six months to a year using a virtual (or fake) investment portfolio.
Simply track stocks you think are good picks as if you’ve already invested in them and check in on them six months or a year down the road to see how you do. This will give you time to teach yourself how to be patient and time the market appropriately.
I’ve only touched the tip of the iceberg when it comes to value investing, but hopefully, this article gave you a taste for what it’s like to think like a true value investor. To go further, I will again encourage you to read The Intelligent Investor by Benjamin Graham.
You can also check out Serenity Stocks’ quick reference guide on the values Benjamin Graham puts in place for picking value stocks. They even have a screener you can play around with.
After that, I’d encourage you to tinker around with a fake portfolio until you really get comfortable analyzing a company’s value. Only then should you begin investing. Once you do, though, you’ll have the patience and smarts to invest like Warren Buffet, ignoring market noise and focusing on solid investments for long-term growth.
If you’re eager to get started as a value investor, consider signing up for a Questrade account. It’s not only our top pick for online brokerages in Canada, but you’ll also get $50 in free trades when you open a new account and start investing with Questrade. That way, you can test drive value investing without spending a lot on fees.