Find out how a value investing approach works.
Stock picking for deep-value bargains
Value investing is probably one of the most timeless investment approaches available to all investors regardless of the asset class. Value investing relies on uncovering stocks undervalued by the market, which means the stock is mis-priced and can be purchased for a discounted price. When the stock's intrinsic value is appreciated by the market, the share price corrects, providing profit to the value investor.
Star investor clout
Self-styled investment moguls such as Warren Buffet have made their fortunes using a value investing philosophy. It was first identified by prolific investors Ben Graham and David Dodd in the 1930s as an effective approach and it is applicable to almost all purchases, from property to autos and consumer goods.
In the philosophy of value investing, the disparity between intrinsic value and market value of a stock exist due to human behaviour; value investors believe the stock market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. It also means that the current performance of a stock does not reflect its intrinsic value.
That in itself is a risk in this strategy as there's no 'correct' intrinsic value or a formula to calculate it. Value investing is subjective and your valuation of a stock can be completely different to that of another investor. Some investors base their assessments on the company's current financial assets and earnings while others base their view completely around the estimation of future growth and cash flows.
'Margin of safety' technique
As there's no clear wrong or right answer to a stock's intrinsic value, this strategy involves a central concept called 'margin of safety'; a simple yet effective technique. By employing margin of safety when buying your value stock, you are giving yourself enough room for error in your calculations of intrinsic value. You could be overconfident and your calculations a little too optimistic, but if you buy at a big enough discount, it would offer you much needed downside protection.
Remember: One of the most important points to remember about value investing is that is a long-term approach to investing which includes an intensive amount of due diligence before buying stocks.
Uncovering 'intrinsic' value
The key to this style of investing involves a comprehensive investigation into a company's business, industry and competitors. Beyond that, a valuation of its assets and cash flow together with detailed analysis of its financial results and historical stock performance are necessary.
Your stock-picking and analytical abilities are tested with this strategy as it is all about identifying stocks with shares price that trade below their intrinsic value. Most investors use valuation multiples such as the stock's
price-to-earnings (P/E) or
price-to-book (P/B) ratio to rate the value of a stock. Typically, value stocks have lower-than-average P/E or P/B and/or high dividend yields.
If the fundamentals of the value stock are compelling enough and the stock is cheap, your aim is to buy it on the expectation that over time, the intrinsic value of your stock will be recognised by the market. In that way, not only are you profiting from capital gains that can be obtained from buying low and selling high, but you also benefit from securing a stream of corporate earnings at a low price.
- An easy to implement strategy with long term tax benefits and lower brokerage fees.
- Employing a high safety of margin reduces the probability of large losses.
- Rewarded by capital appreciation and earnings growth of a stock.
- Intensive research must be conducted and analytical skills are needed.
- Intrinsic value is risk as its subjective with no correct formula behind it.
- Cheap shares trading below intrinsic value can get getting cheaper in a downtrend.
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