Investors often pursue investment strategies based on market capitalization.
Additionally, equities may be viewed through the prism of being either value or growth stocks.
Today we look at value investing.
What exactly is value investing? What are its advantages and potential pitfalls. Should you value invest?
Value Stocks
Stocks in this category are seen as value buys.
That is, the stock is considered undervalued based on quantitative and qualitative analysis.
The objective is to identify companies that trade below their intrinsic (i.e., “true”) value. Then purchase shares and wait patiently for the rest of the world to see what they have missed.
Companies in this category tend to be: established companies that have fallen out of favour and been beaten down in price due to poor performance, bad news, lawsuits, management changes, etc.; smaller companies that are not extensively followed by analysts and the investing public; mature companies that have minimal upside for internal growth, so they pay out their earnings in dividends rather than reinvest in the company’s operations.
Or perhaps entire industries or sectors are depressed. Look at real estate markets in the US and Canada over the last decade. At times, significant bear markets in some regions. Oil and gas is another industry that took a hit in the past few years. Nothing wrong with the companies per se, they just happened to be in a market with low oil prices.
In essence, you are attempting to buy assets that are “on-sale” due to specific circumstances. As the circumstances alleviate, the share price reverts back to its “true” price.
In theory, this is an excellent way to invest. In any other investment you make (house, art, coins, etc.) you always try to find acquisitions being sold at a discount to market value. Better to purchase your home in a down market than to buy the same property when demand is high.
Benjamin Graham and David Dodd are considered the fathers of this investment style. Warren Buffett uses this approach in a slightly modified form. Hard to argue with those investors.
I quite like value investing. But it is not an easy process.
Given the amount of publicly available data, the number of analytical tools one can use to screen stocks, and the sheer volume of investors searching for the next great value stock, it is not simple to find a hidden gem all on your own.
If you lack the time or expertise to do your own in-depth analysis, value equity funds are a good way to invest. Many are professionally managed, albeit often at a relatively high management fee. And by purchasing a number of companies that meet the value criteria, funds spread out the risk of the individual stocks.
Quantitative and Qualitative Analysis
In analyzing companies under a value approach, analysts examine an investment’s fundamentals.
Please refer to my post on Quantitative and Qualitative Analysis for details.
Quantitative analysis is not difficult. Find the data, plug it into the appropriate equation, and you have your result.
Common fundamentals include: price/earnings; price/book; dividend yields. Analysts usually arrive at similar numbers.
The difficulty lies in interpreting those results.
Qualitative Analysis
In value investing, the proper qualitative analysis is what separates value from junk. This is critical, because based on the quantitative data, terrible investments often look like value opportunities.
A low price/earnings ratio may suggest value. Or it may indicate a company heading for difficulties. The same is true for companies with high dividend yields. The exact same ratio in two different companies may indicate the complete opposite future potential.
When we cover the common fundamentals later, we will go through examples.
Qualitative analysis assesses an asset’s systematic and nonsystematic risk factors to make sense of the quantitative results. Risks involving: general economic conditions; management; operations; industry; competitors; customers and suppliers; credit and financial; tax and regulatory; legal.
Intrinsic Value
By conducting both quantitative and qualitative analysis, you attempt to determine a stock’s intrinsic value.
But what is this true value?
And that is the problem with value investing.
What exactly is a stock’s intrinsic value?
As I stated above, most analysts will arrive at similar quantitative results. Then they use quantitative analysis to adjust the data to reflect what they believe is the asset’s “correct” value.
Based on your analysis, you will arrive at one number. Other investors, using the same publicly available data, will arrive at different valuations. Some will be higher, some lower.
No matter how good the analysis, many investors will be incorrect.
And no matter how poor the analysis, some investors will get lucky.
Further, unforeseen events may render even the perfect analysis irrelevant.
Consider the September 11, 2001 terrorist attacks in the US.
On September 10, certain assumptions were made in respect of investments. Interest rates, government spending, oil prices, consumer demand, company revenues, to list a few variables.
On September 11, many factors changed completely. Share prices across the board fell. The US government launched a long and costly war. And so on.
In the space of 24 hours, many assumptions that investors relied on materially changed. And those changes impacted valuation calculations.
In November, 2016, it was widely expected that Hillary Clinton would win the US presidency. That win would usher in her world views and policies. When Donald Trump won, that required a significant shift in thinking. Forecasts and estimates based on assumptions made in late October required adjustments. Adjustments that impacted fundamental analysis.
Considering that just before the election, pollsters showed Clinton with a 95% probability of winning, it is hard to fault analysts for assuming she would win. But she lost and all analysis became erroneous to some degree.
Determining the “real” value for a company is difficult, if not impossible. As the world and company specific factors change, so too does its future value. Without a crystal ball, very hard to get it right.
As well, what you consider an asset’s true value will be different than others. Think of buying or selling a house or used car. Pretty much anything. The value you assign to something is likely different than other parties may believe.
Should You Value Invest?
While it may be impossible to accurately predict a company’s intrinsic value, should you ignore value investing?
Not at all.
Studies often show that value investing outperforms growth strategies.
I do not agree with this as a general statement as other data shows mixed results. But there are some who believe value investing is the only way to go.
I do believe that investors following any investment strategy (e.g., growth, balanced, Japanese equities) must follow the tenets of a value strategy. After all, when you get to the heart of value investing, it is simply common sense.
Find companies that are undervalued relative to what you believe is their true worth.
Then buy their shares.
At its basis, it is that simple.
And even if you follow a growth strategy you need to adhere to these principles.
Apple, Amazon, Facebook, and Google may be considered growth stocks. But even so, you want to buy the one(s) with the best potential. Not the ones that may be overpriced.
Implementing a value investing program requires investing skill. It also takes time and luck to do well picking individual value stocks. It is difficult, but not impossible. As the success of Warren Buffet and others can attest to.
Many investment companies offer value funds. I suggest initially using them if you wish to follow a value strategy.
As you develop experience and confidence in your analysis, then consider trading individual stocks.
