We know Warren Buffett is a well-known value investor, but what does value investing really mean? Regardless of your financial background, here is a straight forward summary of this investment method.
What is value investing ?
Value investing was first developed by Benjamin Graham. He was Warren Buffett's professor at Columbia, and his teachings were later popularized by Warren Buffett's success. Buffet's net worth is now around $85.6 billion and with his success came the fame of the value investing strategy. It is hard to give a simple definition of value investing because it is a whole investment philosophy. In this article, we attempt to break down the philosophy into smaller pieces, and in so doing hopefully shed some light on a definition worthy of value investing.
Finding value stocks via metrics
You do not need to be Warren Buffet to be a value investor, but you do need to understand a few guiding principles behind the philosophy, starting with researching a company. Value stocks are supposed to be the diamond in the rough of stocks, and value investors are renowned for their researching efforts before investing.
It takes time and effort to analyze and understand the core business before you can call it a value stock, but you should know the company's long term plans, its business principles and practices, its financial structure, and its management and governance practices pretty much by heart. Most importantly, you should look at financial metrics that serve as indicators of health and well, value.
- The P/E multiple: The price to earnings ratio is a multiple that helps one understand how much investors are willing to pay for each unit of earning. A P/E ratio of 20 means the stock trades at 20 times the earnings it produces. A value investor looks at a low P/E ratio favorably because it means the market undervalues the earnings. If the value investment is correct and the market values the earnings fairly, the stock price will rise to reflect that.
- The P/B ratio: This ratio is about the net asset value of a company's things. The idea is to look at the worth of a company's things and compare it to what the market thinks of those things. If the ratio is a small number, it shows that the market thinks poorly of those things, and if it is high, the market is confident in those things producing future gains. Value investors want to find bargains with a residual value they can exploit. They will niche out situations where companies they deem good will have small P/B ratios in the hopes that over time the market will correct and reveal the company's true nature.
- Debt to equity ratio: For value investors, it is important that a company relies less on debt than equity to finance their operations. Too much debt (a larger ratio) can pose a risk to a company if it doesn't have the earnings to meet reimbursement obligations so they do not want to see debt becoming a burden in the future. Value investing is conservative in the present in order to gain from a steady and positive future.
- PEG ratio: The price to earnings to growth relationship enhances the P/E ratio by offering more scope on earnings growth. The PEG offers a more complete and forward looking perspective. A low PEG matters to value investors because it indicates a low price to high earnings growth.
Of course, these ratios should be taken with a grain of salt for a couple of reasons. Not all comparable companies use comparable accounting standards, and ratios can focus on before-tax or after-tax numbers. Unfortunately, value investing is not as straight forward as checking a couple of boxes and placing an order. A caveat to keep in mind is with regards to ''value traps''. Be careful not to associate low price and low P/E ratio as the solution to value stocks. There is an ensemble of measures to respect and company risks must be evaluated thoroughly before diving into an order.
Value investors don't ignore markets!
Aside from these metrics, value investors also make room for mistakes with something called a ''margin of safety''. The founding father of value investing, Benjamin Graham, said that he only allowed himself to purchase stocks when they were priced at two thirds of their intrinsic values. In other words, there are many value stocks but few are really great bargains.
Value investors don't believe in the efficient market hypothesis meaning that stock prices already take all the information about a company into account. Many things come into play such as economic downturns, and psychological bias that the market does not capture. This is where the intuition of a value investor comes into play and where anyone can add value.
It's alright to be a contrarian investor in value investing because following the herd is not a good enough excuse to pick a company. If the numbers check out but the company is not well covered by the media that is not a problem. What matters in value investing is to remain rational and not get caught up in the hype, or distracting methods of accounting.
Value investing today:
The antithesis to value investing is growth investing because growth companies have very different metrics, for one they typically have much higher P/E ratios. Growth firms promise nice cashflows in the future so investors are excited to pay a premium today to benefit from an increasing value tomorrow. Value investors don't look at earnings growth the same way and prefer smaller P/E ratios in the hope of future market recognition.
Value firms have been on the backburner since the March crash compared to growth firms. It appears as though value firms have taken more time to recover than growth firms. But it remains to be seen how much further growth firms will climb over time and if there might be a convergence between the two. If anything, this can represent a buying opportunity for value companies as they are slowly coming back to pre crisis levels.
Boiled down value investing
- Pick stocks that appear to trade for less than their intrinsic value.
- Pick stocks that are unloved by the public if their metrics check all the right boxes.
- Patience is key in seeing future returns because it takes time for the markets to reveal gems.
- Value investing is a low risk, conservative investment philosophy on the average.
- Do not follow the hype of the market, follow the set of rules and remain rational in your choices.
- Value stocks have performed more poorly than growth stock in aggregate as of late.
Good luck !
If you are curious to know what Warren Buffett's holding company Berkshire Hathaway invests in, see the imagine below:
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