You can simplify value investing as the buying of stocks at a discount. But even if it sounds as simple as that, it has made fortunes for legendary investors like Warren Buffett.
That being said, you don’t really have to be a legendary investor to gain profits from value investing. To understand how value investing works, here are some of the key principles or insights that successful value investors follow.
It’s not the Same as Speculation
It should be clear from the get-go that value investing isn’t the same as speculation. Value investing requires you to analyze the investment and clear potentials that will secure your principal.
If the strategy doesn’t use thorough analysis, it’s simply speculation.
In other words, value investors are not after the next hot stock in the market. You don’t go after stocks that only has promise. You have to find a stock that shows definite future.
For Benjamin Graham, the father of value investing, value investors look for stocks that have prices substantially lower than its intrinsic value, which may be realized in the future.
Value Investors Prioritizes Intrinsic Value
According to the efficient market hypothesis, the price of a stock instantly reflects all the available information on the company.
That implies that it’s quite impossible to beat the market consistently. So, it’s better for investors to invest in funds that tracks or matches the markets using index funds.
On the flip side, value investors argue that over the longer term, the stock’s price reflects the real value of the company, or its intrinsic value.
This is evident when a company suffers from any event that pummels its stock price temporarily. For instance, even though the company’s fundamentals are solid right, its stock price can decline because of a scandal or a rumor that sends jitters to stockholders.
This Strategy has a Margin of Safety
As we’ve mentioned, the current market price of a stock isn’t always the same as its intrinsic value. We call the difference between those two prices the margin of safety.
Value investors always choose companies that give them large margin of safety, meaning the investment has a lot of upside potential.
To find out a stock’s margin of safety, one classic metric that investors use is the price-to-book ratio. The book value of the company is what you get when you subtract a company’s total liabilities from its total assets.
Value Investors Aim for the Longer Haul
One obvious challenge to value investors is that it’s not really possible to know just how long the intrinsic value will take to be reflected in prices.
It may take months or even years. Sometimes the company may go out of favor with the market. And then its price falls. Investors sell the stock.
Needless to say, you also have to adopt a contrarian attitude. Because, in the short-term, you may see everybody ditching the stock. You may be pressured to do the same.
If you set your sight for the longer term, you may see that the company still can get to its intrinsic value. As long as the analysis is solid, you must stand your ground if that’s what it tells you.
And when the stock price reaches its intrinsic value, you often get generously rewarded.