1. Value Investing: Introduction
  2. Value Investing: What Is Value Investing?
  3. Value Investing: How Stocks Become Undervalued
  4. Value Investing: Finding Undervalued Stocks
  5. Value Investing: Finding Value In Financial Reports And Balance Sheets
  6. Value Investing: Finding Value In Income Statements
  7. Value Investing: Managing The Risks In Value Investing
  8. Value Investing: Famous Value Investors
  9. Value Investing: Couch Potato Value Investing
  10. Value Investing: Common Alternatives to Value Investing
  11. Value Investing: Conclusion

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 to 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 few low-cost index funds that invest in stocks and bonds. 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 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

Warren Buffett uses a holding company called Berkshire Hathaway to buy, hold and sell his investments. Since Berkshire Hathaway is a public corporation (and one of the largest in the Fortune 500, at that), ordinary investors can buy shares of it, and it has achieved a compounded annual gain of about 20% from 1965 to 2016 according to Buffett’s 2016 annual letter to shareholders. That’s about 10% more than the S&P 500, though Buffett has acknowledged that this yardstick is not ideal since Berkshire holds dozens of companies in their entirety. One thing we know for sure: at the company’s 50th anniversary in 2014, its total gain was a tremendous 1,826,163%. (Source: http://fortune.com/2015/02/28/berkshire-after-50-years/)

The company issues two classes of shares. The A shares (ticker symbol NYSE: BRK.A) are expensive, at times trading over $280,000 per share in 2017. If you’re not an institutional investor or a high net worth individual, you’ll want to look at the class B shares (NYSE:BRK.B), which were trading for $186.68 at the time of writing. Class A shares have greater voting privileges and can be converted to class B shares; class B shares have lesser voting rights and cannot be converted to class 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 transaction 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 4.2% of your investment off the bat.

Excerpt from Warren Buffett’s 2017 Berkshire Hathaway Annual Letter to Shareholders

Coattail Investing

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 slashes 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 each quarter 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 following this process, you could see, for example, that as of December 31, 2016, Berkshire Hathaway’s largest holdings included Coca Cola (NYSE: KO), American Express (NYSE: AXP), Phillips 66 (NYSE: PSX), Sanofi (NYSE: SNY) and others.

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 that investment managers do, 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.

As a coattail investor, you could also try to mimic, as closely as possible, the timing and size of institutional investment managers’ purchases. This strategy 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 Invest Like Buffett: 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, stock 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-Focused Mutual Funds and Exchange-Traded Funds

Another value-investing method that doesn’t require you to pick individual stocks is to purchase a value-oriented mutual fund or exchange-traded fund (ETF). 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 and well-respected sources for fund data. (Learn more in Morningstar: A Premier Mutual Fund Source.)

Investing in funds can be easy and inexpensive, but there are several tradeoffs and pitfalls to be aware of.

First, fund fees can eat away at your returns. When you hold a stock long-term, you don’t pay any ongoing fees. When you hold a 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 both mutual funds and ETFs with expense ratios below 0.1%. If you invest $1,000, an expense ratio of 0.1% will only cost you $1 a year. At the time of writing, Vanguard’s Value ETF (VTV)  had an expense ratio of just 0.06%.

These small annual costs are 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 accompanied by lower ongoing expenses. Loads aren’t necessarily a bad thing for buy-and-hold value investors; you might come out ahead by paying these one-time fees depending on how the load fund’s ongoing fees compare to those of similar no-load funds. (Learn more in What’s the difference between a load and no-load mutual fund?)

Comparing Funds to Stocks

Compare fund 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 fund fees — you are, after all, passing the work of picking stocks and managing a portfolio off to a professional, saving you lots of time. 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.

Cost Comparison to Buy and Hold Value Mutual Funds, ETFs and Stocks

Investment

Type

Ticker

Commission

Expense Ratio*

Annual cost per $1,000 invested for 5 years

Cost to buy and hold for 5 years

iShares Russell 1000 Value

ETF

IWD

$4.95

0.20%

$2.99 ($0.99 commission + $2.00 expense ratio)

$14.95 (commission + expense ratio for 5 yrs)

SPDR® Portfolio S&P 500 Value

ETF

SPYV

$4.95

0.04%

$1.39 ($0.99 commission + $0.40 expense ratio)

$6.95 (commission + expense ratio for 5 yrs)

Vanguard Value Index

mutual fund

VIVAX

$9.95

0.18%  (no load)

$2.79 ($0.99 commission + $1.80 expense ratio)

$18.95 (commission + expense ratio for 5 yrs)

Fidelity Value Fund

mutual fund

FDVLX

$9.95

0.67% (no load)

$8.69 ($1.99 commission + $6.70 expense ratio)

$43.45 (commission + expense ratio for 5 yrs)

Berkshire Hathaway

stock

BRKB

$4.95

0.00%

$0.99 (commission / 5)

$4.95

Johnson &  Johnson

stock

JNJ

$4.95

0.00%

$0.99 (commission / 5)

$4.95

*Expense ratios as of Nov. 8, 2017.

The simplified chart above is only for illustrative purposes and does not account for taxes or changes in investment value. While a fund’s expense ratio will be the same no matter where you buy it, commissions can vary considerably by brokerage. The most common commission for stocks and ETFs was $4.95 as of September 2017; stock and ETF commissions range from $0 to $19.95 among the top brokerage firms. The most common commission for mutual funds was $9.95. (Source: Investopedia’s Broker Rating Calculator, Excel file sent to me by Lyndon in September) Many brokerages, such as E*Trade, offer certain ETFs commission free, and it’s even possible to trade stocks commission free through apps such as Robinhood. Mutual funds are often commission free if your purchase them directly from the brokerage that runs them (for example, if you buy a Vanguard fund from Vanguard). (For more, see How Robinhood  Makes Money.)

Now, just because a fund is value-oriented doesn’t mean that it is the best-performing 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 more than just value stocks, so you might not be getting exactly what you bargained for. Furthermore, overdiversification 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.)

Value investing via funds does not totally eliminate the legwork of choosing investments. Instead of researching individual stocks, you’ll have to research individual 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 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.

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 overdiversification (from a value-investor’s perspective) and may not provide the level of returns associated with picking winning individual value stocks. (Read ETFs For A Low-Cost, Long-Term Portfolio to learn more.)

Couch-Potato Value Investing Summary

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 value stocks. These alternatives may be less exciting to you and may not offer the upside potential investors can achieve by picking winning companies. On the other hand, they require a smaller time investment and may be less risky.

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 index investing.


Value Investing: Common Alternatives to Value Investing
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