"What gives you opportunities is other people doing dumb things." That's how Warren Buffett, a famed value investor, recently described the philosophy that has made him one of the wealthiest people in the world. Value investing (investing in undervalued assets) is mainly about seizing opportunities that other investors miss or are unwilling to pursue. It's often presented as an alternative to growth investing, but both strategies may be incorporated into a well-balanced financial plan.
WHAT ARE THE CORE PRINCIPLES OF VALUE INVESTING?
Value investing can be complex and not suitable for everyone. Before making portfolio changes, it's very important that all investors understand the basic philosophies and strategies behind value investing and consult their investment advisors for practical guidance.
Some of the fundamental principles behind successful value investing are:
Intrinsic value drives investment decisions.
Value investors look for stocks priced below their true worth. To determine if a given company's stock is a good investment, investors must have a good sense of its "true" or intrinsic value. The goal is to buy the stock at a discount now and wait for it to regain its full value before selling.
Investors and their advisors can measure a security's intrinsic value in many ways. These include relatively straightforward metrics, such as a company's price-to-earnings ratio and more sophisticated financial models and analyses.
The margin of safety is a crucial metric.
This one is common sense, but it bears mentioning: Value investors are typically looking for wide safety margins. (For example, a stock with an intrinsic value of $100 and selling for $85 has a 15% margin of safety.) A wide margin acts as insurance against the possibility that your assessment of the stock's intrinsic value is too high. If the stock you bought for $85 was worth $90 instead of the $100 you thought, you would make little profit. Your investment dollars could have been better used somewhere else.
Think long-term growth, not short-term gains.
Value investing probably isn't the right strategy for investors looking to make quick profits. When a stock is selling for less than its intrinsic value, it's often an indication that something has gone awry for that company, its industry and potentially the larger economy. For example, bad publicity has hurt the company's reputation, or a struggling economy has tanked stock prices. (Buffett has famously made notable strategic value investments during financial crises.) It can take years for the market to right itself and for a company to return to or exceed its intrinsic value. This strategy requires patience.
A company's potential might be more meaningful than its stock price.
Because value investing is about betting that a company will gain value in the future, you need to have confidence in the earning potential of any companies you invest in. That means looking at factors such as how good the management team is. What are their business practices like? What industry trends might affect the demand for this company's services in the future? How might changing technology affect this company's position in the market? With long-term growth as the goal, you want to feel confident any company you back is capable of future success.
Value investing requires a specific mindset.
Using this strategy often means taking a contrarian approach to investing. People who practice value investing often buy stock when most of their peers are selling or sell when everyone else is buying. It takes a particular kind of mindset to be comfortable committing to this strategy and not second-guessing every decision you make. Investors should be okay with not engaging in herd behavior.
Failure is an option.
Value investing is inherently risky as a long-term strategy to grow your wealth. It's always possible that you will hold onto undervalued stocks for many years without them ever rebounding. Even if you invest in a company with tremendous potential and the best management team in the world, many things could go wrong to force the business to fail. Because you can't count on guaranteed returns from value investing, portfolio balance is vital for ensuring you stay on track with your financial goals.
NEED HELP WITH A VALUE INVESTING STRATEGY?
Sachetta's investment advisors always encourage clients to ask questions about new strategies or unfamiliar investment concepts they're curious about. If you'd like to try value investing or need help evaluating whether it fits your risk tolerance and goals, we're happy to discuss specifics. Contact us today!