The Basis of Value Investing
You might have heard about a relatively simple investment strategy – value investing. Do you want to know what is value investing and how to use this strategy to make good profit? Read on to find brief answers to these questions and if you decide to dive in deeper and take advantage of the market overreaction to bad or good news, then consider going through value investing training to acquire necessary knowledge and skills.
What is Value Investing?
Value investing is the purchase of shares at a price lower than their real value. The philosophy of this strategy has two concepts – market price and cost. Price is what you pay, value is what you buy. According to value investing strategy, the stock market is not efficient, so there may be undervalued and overvalued assets on the market. An undervalued stock means its market price is lower than its true value.
The founders of the value investing are Benjamin Graham and David Dodd, who laid the foundation of this trade strategy in the US in the 1930s.The value investor is trying to find such undervalued stocks, as he or she believes that in the future the market will overestimate them, and the market price will be equal to the true one. The essence of the value investing is well conveyed by the phrase “buy 1 dollar for 60 cents”.
Value investing involves a detailed fundamental analysis of the industry and enterprises, and slightly breaks the general principles of market efficiency and risk. In live courses on value investing, you can see how professional investors do this analysis and determine which stocks to invest into. Value investing is designed for long-term investment, and is especially effective during periods of market recession, when many good companies are undervalued.
Value Investing Strategy
Most market participants do not see any difference between the “price” and “value” of a share, but value investing strategy places the most importance on the difference between the two. Benjamin Graham managed to label it surprisingly correctly: “Price is what you pay, and value is what you get.”
Estimation of the true value is an investor’s attempt to determine what the stock actually costs, that is, to find out the price at which it would sell if the market gave it the correct price. In value investing courses, you can learn how to estimate this value. In his book, Graham recommends investing in stocks that meet the following parameters:
- Adequate company size
- Stable financial situation:
- Current assets are twice as large as current liabilities.
- Long-term liabilities should not exceed the value of net current assets (working capital).
- Stable profit – the company should not have losses in the past 10 years.
- Dividend history – a company must be paying dividends for at least 20 years.
- Profit growth – the company’s profit over 10 years should grow by at least 1/3.
- The optimal value of the P/E ratio is no more than 15.
- The optimal value of the P/B ratio is no more than 1.5.
- The product of the P/E and P/B ratios should not exceed 22.5.
The most important concept in the value investment that Benjamin Graham has introduced is the safety margin — the difference between the market price and the intrinsic value of the stock. The lower the market price of the stock compared to the true value, the greater the safety margin.
Safety margin serves as a protection and reduces the influence of negative factors and errors in calculations. By purchasing a stock with sufficient security margin, an investor can be sure that even development of negative events will not be able to significantly affect the results of investment. According to Graham, the use of the concept of safety margin security is what distinguishes investment from speculation.
In fact, strategies that do not correlate the price and value of a stock have little to do with investing. It is rather speculation in the hope that prices will rise than the investor’s belief that the price he paid is lower than the value received. The purchase price determines the return on investment, and therefore should not be overlooked.
Even with a long horizon of investments, the investor should not ignore the purchase price, relying on the fact that long-term growth will cover everything. Buying the right stocks at high prices at the wrong time is fraught with losses. Buying incorrectly chosen stock leads to even greater losses.
Warren Buffett, the richest investor in the world, studied and worked with Graham at the beginning of his career, after which he founded his partnership, and later the investment company Berkshire Hathaway. Buffett introduced a new concept: “buy great companies at a reasonable price” instead of “buy good companies at a bargain price.” Buffett also introduced a number of his criteria:
- The company’s business should be simple and straightforward.
- Company profits must be predictable and have a consistent growth history.
- The company should have favorable long-term prospects.
- Company management must be honest and responsible.
- The company must have a high return on equity and a net profit margin.
It is important to understand that value investing is aimed precisely at high-quality, good companies with great potential, and not just at cheap stocks, the price of which has dropped. A crisis is a great time for a value investor. During a recession, when stock markets crawl in search of a new bottom, value investing becomes even more rewarding than in the normal economy.
The basis for successful value investing is a thorough study of the company’s activities, and not just a comparison of various coefficients. Making a deal is quite simple – it is much more difficult to do all the necessary work prior to a successful deal. In order to choose good stocks, you first need a clear head and critical thinking. In addition, value investing courses online will make it easier to find the right stocks to minimize your losses and determine when to buy or sell them to make profit.
You should remember that value investor is a patient investor. He enters the market when it is low-priced, and not when it is growing rapidly. It is the patience that allows such an investor to choose the right time to buy, and as a result receive a higher return on investments.