Today, it’s time to look at value investing, a strategy that has seriously underperformed in recent years.
Hope you gain some good insights!
Contents
- Introduction
- How To Find An Undervalued Stock
- Value Investors Are Skeptical
- Patience And Diligence Are Key!
- Key Takeaways
Introduction
Value investing is an investing strategy that consists of choosing stocks that appear to be trading for less than their book or intrinsic value.
A value investor actively selects stocks that they perceive the market is undervaluing.
Value investors believe that the market overreacts to positive and negative news, allowing them to profit off movements in the market caused by investors ‘overreaction’.
Warren Buffett is the best-known value investor, and possibly the wealthiest, along with many others such as Charlie Munger, Benjamin Graham (famous author of the ‘Intelligent Investor’) and Seth Klarman (billion-dollar hedge fund manager).
The concept of value investing is quite primitive when stripped down to its basic form – if you understand the true value of an entity, you can save a lot of money if you purchase it on sale.
It requires detailed research work to be a value investor, doing the due diligence of estimating the market value of a stock before opening a position in that entity.
Traders who maintain their open positions for extended periods of time reap the rewards of ever-increasing market value on the stocks they purchased.
How To Find An Undervalued Stock
There are many possible methods to find the intrinsic value of a stock – it is important to combine a plethora of financial analysis and company analysis when calculating the value of a stock.
Price-to-book is a financial indicator that reflects the value of a company’s assets and assesses them in relation to the stock’s price. If the output value is lower than the value of the assets, then it reflects an undervalued stock – supposing the company is not in financial disarray.
Price-to-earnings is another well-used indicator that illustrates a company’s history of earnings to reflect if the price of the stock is reflective of the revenue or undervalued.
There are several other indicators that value investors can utilize to determine the value of a stock including pointers that display sales, equity, debt, etc.
Value Investors Are Skeptical
The efficient-market hypothesis which states that the value of a stock already takes into account all the information about a company is not accepted amongst value investors.
Value investors must be skeptical of this theory and always have the idea that there are a variety of reasons that a stock could be undervalued in the forefront of their mind when trading.
A reason why a stock might be undervalued is that the economy is performing badly and investors unloading their positions in a panic – value investors must identify the market when it is in this stage and invest at the low point of a stock’s value.
An efficient value investor will also be able to identify stocks that are overpriced, for example, traders getting too excited about an unverified piece of new technology, as seen during the dot-com bubble.
The media can be the leading force in the undervaluing of a stock – a lack of reporting may cause the stock to trade ‘under the radar’ meaning the lack of investors will lead to a price drop.
Patience And Diligence Are Key!
When it comes to evaluating the intrinsic value of a stock it can be extremely subjective – two investors may have the same data, but after analyzing it, come to two different conclusions.
Some traders may only study the existing financials of a company before investing, spending little time estimating future growth potential.
Others may focus greatly on the estimated growth and cash flows rather than the current financial position, and some may do both.
However a trader invests, the underlying methodology of value investing is to open positions in stocks for less than they are worth, hold them for a long time, and profit when the market realizes their intrinsic value.
Instant gratification is an unknown term to value investors – it is unrealistic to purchase a stock at the beginning of the week for $5 and sell it for $50 a few days later.
Value investors may hold their investment for years before closing their positions, only because it took that long for the market to realize the true value of the entity.
Key Takeaways
Value Investing is an outstanding trading strategy if an investor is looking for large long-term gains on their initial capital.
However, it requires thorough research by the investor into the intrinsic value of a stock using a variety of different methods.
Being objective, patient, and diligent are fundamental skills for a value investor to ensure they are in the best position to profit from market increases and/or the market realization of the true value of a stock.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
