At this point, you might be thinking that value investing sounds like a lot of work. You might also be wondering if you really have the patience or skill to do the analysis and pick winning stocks. If so, take heart – it is possible to become a value investor without ever reading a 10-K.
Couch potato investing is a passive strategy of buying and holding a very limited number of low-cost stock and bond index funds. To become a couch potato value investor, you would want to buy and hold a limited number of low-cost value investing vehicles for which usually someone else has done the investment analysis. This section provides several options for pursuing such a strategy. (To learn more about couch potato investing, read Why It Pays To Be A Lazy Investor.)
Buying Shares Of Berkshire Hathaway
As you probably know, legendary value investor Warren Buffett uses a holding company called Berkshire Hathaway to buy, hold and sell his investments. Since Berkshire Hathaway is a public corporation, ordinary investors can buy shares of it, and it has achieved a compounded annual gain of 20.2% from 1965 to 2010 according to Buffett's 2010 annual letter to shareholders. That's 10.8% more than the S&P 500.
The company issues two classes of shares. The A shares (ticker symbol NYSE:BRK.A) are very expensive, at times trading over $130,000.00 per share in 2011. If you're not an institutional investor or a very wealthy individual, you'll want to look at the class B shares (NYSE:BRK.B), which were trading for $79.48 at the time of publication. Class A shares have greater voting privileges and can be converted to class B shares; class B shares have lesser voting privileges and cannot be converted to A shares. For the average investor, the difference in the two share classes is irrelevant. (Learn more in Warren Buffett's Best Buys.)
Unlike owning value mutual funds or ETFs, there are no ongoing fees associated with owning shares of stock. You will have to pay a small commission any time you place a buy or sell order, but if you buy a large number of shares at once and hold them, your ownership costs become negligible. On the other hand, if you bought one share of BRK.B a month and paid a $7.95 commission each time, you'd be losing 10% of your investment off the bat.
Interestingly, since Berkshire Hathaway is a stock, you could actually apply value investing principles to it and attempt to buy it when it was trading below its intrinsic value. Also investors are always questioning whether the company's days of amazing returns are over. Buffett himself has said that because the company manages such large amounts of capital, outsized returns are no longer possible, though better-than-average returns are still the company's goal. (To learn more about why this might be the case, check out Why Warren Buffett Envies You.)
Coattail investors follow the investing behavior of successful investors instead of doing their own research. This approach may be lazy, but it can also be smart. It seriously reduces the time required to track down viable stock picks and can even take the guesswork out of buy and sell timing. So how do you know what successful value investors are doing?
Institutional investment managers with stock portfolios worth $100 million or more must file SEC form 13-F quarterly listing all the securities and the number of shares of each that they hold in their accounts. You can find these filings through the SEC's online EDGAR database. Just search for the name of the investment company whose holdings you want to research and then do a second search for their 13-F filings. By doing this, for example, you could see that as of December 31, 2010, Berkshire Hathaway's holdings included Coca Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Kraft Foods (NYSE:KFT), Sanofi-Aventis ADR (NYSE:SNY) and a couple dozen other companies.
Once you know which securities your favorite investment manager holds, you can use this list as a jumping-off point to perform your own analysis and decide which of those stocks you want to buy. It wouldn't be wise to just jump into the market and buy all of them because value investing is not just about the companies you own, but about acquiring shares of those companies when they are trading at a discount to their intrinsic value. So if Coca Cola were overvalued at the time of your research, you might determine a price you would be willing to pay for its shares and hold off actually making a purchase until later (perhaps years later) in order to build in your margin of safety. (Discover how to search for potential long term picks in Finding Solid Buy-And-Hold Stocks.)
If you want to mimic not just stocks and timing but also hold the same percentages of each investment in your portfolio, you'll need to determine what percentage each stock makes up in the investment manager's portfolio and then apply those percentages to your own significantly smaller pile of investment capital. Keep in mind that the holdings declared on 13-F forms rarely provide a complete picture of an investor's portfolio. You will not be able to find out how much cash they are holding, for example. (More about this in a moment.)
As a coattail investor, you could also try to mimic, as closely as possible, the timing and size of institutional investment managers' purchases. This is difficult, however, for a couple of reasons. While it is possible to infer trading activity by comparing the previous quarter's 13-F to the most recent 13-F, this information will always be somewhat out of date. Companies have 45 days after the quarter ends to file form 13-F (and they often take advantage of the full 45-day window), so the information you're viewing will often be at least 45 days old – and that's if you read the 13-F the day it comes out. Even though value investing is a buy-and-hold strategy, meaning that there shouldn't be a great deal of trading activity going on in a value investor's portfolio, you never know what, when or why they might decide to buy or sell. If you aren't making the same buy, sell and hold decisions for the same reasons, you might not be able to match their returns. (For more on coattail investing read Build A Baby Berkshire.)
Another problem is that form 13-F does not tell the whole story. If the value investor you are following holds any positions of fewer than 10,000 shares or with a market value of less than $200,000, they won't appear on form 13-F. Also, not all types of investments must be reported on form 13-F. Only exchange-traded stocks, equity options, warrants, shares of closed-end investment companies, ETFs and some convertible debt securities must be reported. If your favorite investor owns anything not required to be reported, you aren't getting the full picture.
It may be possible to learn about their other holdings through research (for example, it is widely known that Seth Klarman, founder of the Baupost Group, isn't afraid to hold lots of cash), but the information may simply be unavailable. As a result, form 13-F might make it look like 30% of an investment manager's portfolio is in Coca Cola stock, but if you factored in the unreported assets, it might turn out that they only have 10% of their investment capital allocated to Coca Cola. If you're not concerned about mimicking allocation percentages and don't read too much into how many shares of a company an investor owns, this shortcoming of the 13-F may not matter to you.
Value-Investing Mutual Funds
Another value-investing method that doesn't require you to pick individual stocks is to purchase a value-oriented mutual fund. You can find mutual funds that meet your investment criteria in the same way that you find stocks – by using a screening tool. Morningstar is one of the most popular sources for mutual fund data.
Investing in mutual funds can be easy and inexpensive, but there are several tradeoffs and pitfalls to be aware of.
First, mutual fund fees can really eat away at your returns. When you hold a stock long-term, you don't pay any ongoing fees. When you hold a mutual fund long-term, you pay fees constantly, often without realizing it. To find out how much these fees are, look at the fund's expense ratio. The expense ratio covers the fund's advertising, management, administrative, operating and other costs. These days, it is possible to invest in mutual funds with expense ratios as low as 0.1%. If you have invested $1,000, an expense ratio of 0.1% will only cost you $1 a year. (Looking for current mutual fund information? We'll look at one of the places to start your search, see Morningstar Lights The Way.)
That's no big deal, but as your portfolio increases in size, even a miniscule expense ratio will matter more. If you have $100,000 in that mutual fund, the expenses increase to $100 a year. If you held that same $100,000 in stocks, you would be able to save that $100 a year. Although you would pay stock trading fees, if you're buying and holding a limited number of companies, these fees probably won't amount to $100 annually.
Mutual funds also sometimes have loads, which are percentage fees that you pay when you buy and/or sell your investment. The loads may be instead of or in addition to the ongoing expenses we just discussed. If the fund only has a load and no ongoing fees, you might do okay if you're holding your investments long-term – you might even be better off than you would be by paying the ongoing fees. But if a fund has both types of expenses, look out. (Some funds let you cut out the middleman – and the fees. Read The Lowdown on No-Load Mutual Funds.)
Comparing to Stocks
Compare these expenses to the commissions for trading stocks and see if you think the difference is worth it. It's not necessarily a bad thing to pay mutual fund fees – you are, after all, passing the work of picking stocks and managing a portfolio off to a professional. But you should be aware of the effect that even small fees can have on your long-term investment returns and make a conscious choice to incur this expense.
Second, just because a mutual fund is value-oriented doesn't mean that it is the best-performing mutual fund out there for the level of risk you're willing to take on. You might get the same or better returns by investing in, say, a balanced fund that tracks both the S&P 500 and a bond index. Also, mutual funds that call themselves value funds might be invested in a lot more than just value stocks, so you might not be getting exactly what you bargained for. Furthermore, over diversification is not a value investing principle, and some value funds may hold many more than the 10 to 50 stocks recommended by successful value investors. (Learn more in Top 4 Signs Of Over-Diversification.)
Third, value investing via mutual funds does not totally eliminate the legwork of choosing investments. Instead of researching individual stocks, you'll have to research mutual funds. You'll want to look at the fees, of course, and see how the fund's investment philosophy compares to your objectives. You'll also have to be alert for changes – for example, fund managers come and go, and if the new fund manager has a different philosophy than the old one, you may no longer be holding the investment you think you are.
Value investing mutual funds may not hold their stocks for as long as a typical value investor would, which not only brings into question whether the fund manager is truly a value investor, but also has tax consequences. Look at the fund's asset turnover percentage to determine how much buying and selling activity is going on within a fund. Mutual funds are required to pay out 90% of their earnings to investors every year, which can create ongoing tax liabilities that will eat away at your returns.
Exchange-traded fund (ETF) screeners make it possible to find exchange-traded funds that meet your criteria for fund objectives, portfolio composition, trading characteristics, performance, volatility, fundamentals and tax considerations. ETFs trade differently than mutual funds and often have lower operating expenses. They are also more tax efficient. Unlike stocks, some ETFs can be purchased commission-free through a brokerage account. Like mutual funds, ETFs can suffer from over diversification (from a value-investor's perspective) and may not provide the level of returns associated with picking winning individual value stocks.
Buying shares of Berkshire Hathaway, practicing coattail investing, buying into value-oriented mutual funds and purchasing shares of value-oriented ETFs are all viable alternatives to picking individual stocks. They aren't as exciting and generally do not offer the high returns investors can achieve by picking winning companies. On the other hand, they require a smaller time investment and may be less risky. (Learn how to apply this to your investing strategy, read ETFs For A Low-Cost, Long-Term Portfolio.)
In case you're not sold on value investing, in the next section we'll discuss some common alternative investment styles, such as growth investing and investing in index funds.Value Investing: Common Alternatives to Value Investing
ETFs & Mutual FundsLearn how to buy mutual funds online; discover which websites offer mutual fund trading services, how to choose a fund and typical fees.
ETFs & Mutual FundsLearn about the advantages of investing in mutual funds rather than individual stocks, including the benefits of affordability, oversight and diversification.
TradingGet a piece of Warren Buffett's profit by using Form 13F to coattail his picks.
ETFs & Mutual FundsCreating your own mutual fund can save you the fees that cut into your profits. Find out how.
ETFs & Mutual FundsLearn how to get diversification, liquidity and professional management at an affordable price.
ETFs & Mutual FundsMake sure to review this guide on the dos and don'ts of mutual fund trading before you invest, including how trades are executed and which fees to look out for.
ETFs & Mutual FundsUnhappy with your mutual fund's returns and thinking of investing elsewhere? Read this article first.
ETFs & Mutual FundsMutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
ETFs & Mutual FundsHere's how to find the right mutual fund using five considerations to narrow down your choices.
RetirementChoosing between ETFs and mutual funds depends on your knowledge of the stock and bond markets – and on how hands-on you want to be in managing your portfolio.