Unlike some investment strategies, value investing is pretty simple. It doesn't require that you have an extensive background in finance (although understanding the basics will definitely help), sign up for an expensive subscription service or understand how to analyze squiggly lines on charts. If you have common sense, patience, money to invest and the willingness to do some reading and accounting, you can become a value investor. Here are five fundamental concepts you'll need to understand before getting started.
Value Investing Fundamental No. 1: Companies Have Intrinsic Value
The basic concept behind value investing is so simple that you might already do it on a regular basis. The idea is that if you know the true value of something you can save a lot of money if you only buy things when they're on sale.
Most folks would agree that whether you buy a new TV when it's on sale or when it's at full price, you're getting the same TV with the same screen size and the same picture quality. The obvious assumption that we have to make is that the value of the TV will not depreciate with time as new technology becomes available. Stocks are the same way: the company's stock price can change even when the company's intrinsic value is the same. Stocks, like TVs, go through periods of higher and lower demand. These fluctuations change prices, but they don't change what you're getting.
Many savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year. Stocks work the same way. The only difference is that, unlike TVs, stocks will not be on sale at predictable times of year like Black Friday and their sale prices won't be advertised. If they were, stocks on sale would be less of a bargain because more people would know about the sale and drive the price up. If you're willing to do the detective work to find these secret sales, you can get stocks at bargain prices that other investors will be oblivious to.
Value Investing Fundamental No. 2: Always Have a Margin of Safety
Buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. It also makes you less likely to lose money if the stock doesn't perform as you hope. This principle, called the margin of safety, is one of the keys to successful value investing. Unlike speculative stocks whose price can plummet, it is less probable that value stocks will continue to experience price declines.
You might already apply this principle when you shop. When you buy new clothes, maybe you don't like to pay full price because sometimes an article of clothing just doesn't work out. It might look good and feel comfortable in the store, but then when you wear it in real life, it feels too tight or too loose or it fades or shrinks in the washing machine. If you buy a shirt on sale for $20 instead of buying it at full price for $60, you will only lose $20 on a bad shirt purchase. If you pay $60, your loss will be significantly greater. By purchasing the shirt on sale for $20, you limit your potential loss. On the other hand, you might end up wearing the shirt a hundred times, making it a great bargain at only $20. Either way, you're better off buying the shirt for $20 than for $60. Of course, unlike stocks, your clothes won't appreciate in value and you won't sell them for a profit later.
Value investors implement the same sort of reasoning. If a stock is worth $100 and you buy it for $66, you'll make a profit of $34 simply by waiting for the stock's price to rise to the $100 it's really worth. On top of that, the company might grow and become more valuable, giving you a chance to make even more money. If the stock's price rises to $110, you'll make $44 since you bought the stock on sale. If you had purchased it at its full price of $100, you would only make a $10 profit. Benjamin Graham, the father of value investing, only bought stocks when they were priced at two-thirds or less of their intrinsic value. This was the margin of safety that he felt was necessary to earn the best returns while minimizing investment downside.
Value Investing Fundamental No. 3: The Efficient-Market Hypothesis Is Wrong
Value investors don't believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account. Value investors believe that sometimes stocks are underpriced or overpriced. For example, a stock might be underpriced because the economy is performing poorly and investors are panicking and selling all their stocks (think Great Recession). Or it might be overpriced because investors have gotten overly excited about a new technology that hasn't proven itself yet (think dot-com bubble).
Value Investing Fundamental No. 4: Successful Investors Don't Follow the Herd
Value investors possess many characteristics of contrarians – they don't follow the herd. Not only do they reject the efficient-market hypothesis, but when everyone else is buying, they're often selling or standing back. When everyone else is selling, they're buying or holding. Value investors don't buy the most popular stocks of the day (because they're typically overpriced), but they are willing to invest in companies that aren't household names if the financials check out. They also take a second look at stocks that are household names when those stocks' prices have plummeted. Value investors believe companies that offer consumers valuable products and services can recover from setbacks if their fundamentals remain strong.
Value investors only care about a stock's intrinsic value. They think about buying a stock for what it actually is – a percentage of ownership in a company. They want to own companies that they know have sound principles and sound financials, regardless of what everyone else is saying or doing.
Value Investing Fundamental No. 5: Investing Requires Diligence and Patience
Value investing is a long-term strategy – it does not provide instant gratification. You can't expect to buy a stock for $66 on Tuesday and sell it for $100 on Thursday. In fact, you may have to wait years before your stock investments pay off. (The good news is that long-term capital gains are taxed at a lower rate than short-term investment gains.)
What's more, value investing is a bit of an art form – you can't simply use a value-investing formula to pick the right stocks which fit the desired criteria. Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy even though you will occasionally lose money.
Also, sometimes you'll decide that you want to invest in a particular company because its fundamentals are sound, but you'll have to wait because it's overpriced. Think about when you go to the store to buy toilet paper: you might change your mind about which brand to buy based on which brand is on sale. Similarly, when you have money saved up to invest in stocks, you won't want to buy a stock just because it represents a share of ownership in your favorite company – you'll want to buy the stock that is most attractively priced at that moment. And if no stock is particularly well priced at the moment, you might have to sit on your hands and avoid buying anything. (Thankfully, stock purchases, unlike toilet paper purchases, can be postponed until the time is right.)
Next, we'll discuss how stocks become undervalued.Value Investing: How Stocks Become Undervalued
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