Value Investing

investopedia.com/terms/v/valueinvesting.asp

By Adam
Hayes

What Is Value Investing?

Value investing is an investment strategy that involves picking stocks that appear to be
trading for less than their intrinsic or book value. Value investors actively ferret out
stocks they think the stock market is underestimating. They believe the market
overreacts to good and bad news, resulting in stock price movements that do not
correspond to a company's long-term fundamentals. The overreaction offers an
opportunity to profit by buying stocks at discounted prices—on sale.

Warren Buffett is probably the best-known value investor today, but there are many
others, including Benjamin Graham (Buffet's professor and mentor), David Dodd,
Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-
fund manager, Seth Klarman.

Key Takeaways
Value investing is an investment strategy that involves picking stocks that appear
to be trading for less than their intrinsic or book value.

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 Value investors actively ferret out stocks they think the stock market is
underestimating.
Value investors use financial analysis, don't follow the herd, and are long-term
investors of quality companies.

How Value Investing Works

The basic concept behind every-day value investing is straightforward: If you know the
true value of something, you can save a lot of money when you buy it on sale. Most folks
would agree that whether you buy a new TV on sale, or at full price, you’re getting the
same TV with the same screen size and picture quality.

Stocks work in a similar manner, meaning the company’s stock price can change even
when the company’s value or valuation has remained the same. Stocks, like TVs, go
through periods of higher and lower demand leading to price fluctuations—but that
doesn't change what you’re getting for your money.

Just like savvy shoppers would argue that it makes no sense to pay full price for a TV
since TVs go on sale several times a year, savvy value investors believe stocks work the
same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year
such as Black Friday, and their sale prices won’t be advertised.

Value investing is the process of doing detective work to find these secret sales on stocks
and buying them at a discount compared to how the market values them. In return for
buying and holding these value stocks for the long-term, investors can be rewarded
handsomely.

Value investing developed from a concept by Columbia Business School professors

Benjamin Graham and David Dodd in 1934 and was popularized in Graham's 1949
book, The Intelligent Investor.

Intrinsic Value and Value Investing

In the stock market, the equivalent of a stock being cheap or discounted is when its
shares are undervalued. Value investors hope to profit from shares they perceive to be
deeply discounted.

Investors use various metrics to attempt to find the valuation or intrinsic value of a
stock. Intrinsic value is a combination of using financial analysis such as studying a
company's financial performance, revenue, earnings, cash flow, and profit as well as
fundamental factors, including the company's brand, business model, target market,
and competitive advantage. Some metrics used to value a company's stock include:

Price-to-book (P/B) or book value or, which measures the value of a company's assets
and compares them to the stock price. If the price is lower than the value of the assets,
the stock is undervalued, assuming the company is not in financial hardship.

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Price-to-earnings (P/E), which shows the company's track record for earnings to
determine if the stock price is not reflecting all of the earnings or undervalued.

Free cash flow, which is the cash generated from a company's revenue or operations
after the costs of expenditures have been subtracted. Free cash flow is the cash
remaining after expenses have been paid, including operating expenses and large
purchases called capital expenditures, which is the purchase of assets like equipment or
upgrading a manufacturing plant. If a company is generating free cash flow, it'll have
money left over to invest in the future of the business, pay off debt, pay dividends or
rewards to shareholders, and issue share buybacks.

Of course, there are many other metrics used in the analysis, including analyzing debt,
equity, sales, and revenue growth. After reviewing these metrics, the value investor can
decide to purchase shares if the comparative value—the stock's current price vis-a-vis its
company's intrinsic worth—is attractive enough.

Margin of Safety
Value investors require some room for error in their estimation of value, and they often
set their own "margin of safety," based on their particular risk tolerance. The margin of
safety principle, one of the keys to successful value investing, is based on the premise
that buying stocks at bargain prices gives you a better chance at earning a profit later
when you sell them. The margin of safety also makes you less likely to lose money if the
stock doesn’t perform as you had expected.

Value investors use the same sort of reasoning. If a stock is worth $100 and you buy it
for $66, you’ll make a profit of $34 simply by waiting for the stock’s price to rise to the
$100 true value. On top of that, the company might grow and become more valuable,
giving you a chance to make even more money. If the stock’s price rises to $110, you’ll
make $44 since you bought the stock on sale. If you had purchased it at its full price of
$100, you would only make a $10 profit. Benjamin Graham, the father of value
investing, only bought stocks when they were priced at two-thirds or less of their
intrinsic value. This was the margin of safety he felt was necessary to earn the best
returns while minimizing investment downside.

Markets are not Efficient

Value investors don’t believe in the efficient-market hypothesis, which says that stock
prices already take all information about a company into account, so their price always
reflects their value. Instead, value investors believe that stocks may be over- or
underpriced for a variety of reasons.

For example, a stock might be underpriced because the economy is performing poorly
and investors are panicking and selling (as was the case during the Great Recession). Or
a stock might be overpriced because investors have gotten too excited about an
unproven new technology (as was the case of the dot-com bubble). Psychological biases
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can push a stock price up or down based on news, such as disappointing or unexpected
earnings announcements, product recalls, or litigation. Stocks may also be undervalued
because they trade under the radar, meaning they're inadequately covered byanalysts
and the media.

Don't Follow the Herd

Value investors possess many characteristics of contrarians —they don’t follow the herd.
Not only do they reject the efficient-market hypothesis, but when everyone else is
buying, they’re often selling or standing back. When everyone else is selling, they’re
buying or holding. Value investors don’t buy trendy stocks (because they’re typically
overpriced). Instead, they invest in companies that aren’t household names if the
financials check out. They also take a second look at stocks that are household names
when those stocks’ prices have plummeted, believing such companies can recover from
setbacks if their fundamentals remain strong and their products and services still have
quality.

Value investors only care about a stock’s intrinsic value. They think about buying a stock
for what it actually is: a percentage of ownership in a company. They want to own
companies that they know have sound principles and sound financials, regardless of
what everyone else is saying or doing.

Value Investing Requires Diligence & Patience

Estimating the true intrinsic value of a stock involves some financial analysis but also
involves a fair amount of subjectivity—meaning at times, it can be more of an art than a
science. Two different investors can analyze the exact same valuation data on a
company and arrive at different decisions.

Some investors, who look only at existing financials, don't put much faith in estimating
future growth. Other value investors focus primarily on a company's future growth
potential and estimated cash flows. And some do both: Noted value investment gurus
Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for
several years are both known for analyzing financial statements and looking at valuation
multiples, in order to identify cases where the market has mispriced stocks.

Despite different approaches, the underlying logic of value investing is to purchase

assets for less than they are currently worth, hold them for the long-term, and profit
when they return to the intrinsic value or above. It doesn't provide instant gratification.
You can’t expect to buy a stock for $50 on Tuesday and sell it for $100 on Thursday.
Instead, you may have to wait years before your stock investments pay off, and you will
occasionally lose money. The good news is that, for most investors, long-term capital
gains are taxed at a lower rate than short-term investment gains.

Like all investment strategies, you must have the patience and diligence to stick with
your investment philosophy. Some stocks you might want to buy because the
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fundamentals are sound, but you’ll have to wait if it’s overpriced. You’ll want to buy the
stock that is most attractively priced at that moment, and if no stocks meet your criteria,
you'll have to sit and wait and let your cash sit idle until an opportunity arises.

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Value investing guru Benjamin Graham argued that an undervalued stock is priced at
least a third below its intrinsic value.

Why Stocks Become Undervalued

If you don’t believe in the efficient market hypothesis, you can identify reasons why
stocks might be trading below their intrinsic value. Here are a few factors that can drag
a stock’s price down and make it undervalued.

Market Moves and Herd Mentality

Sometimes people invest irrationally based on psychological biases rather than market
fundamentals. When a specific stock’s price is rising or when the overall market is
rising, they buy. They see that if they had invested 12 weeks ago, they could have earned
15% by now, and they develop a fear of missing out. Conversely, when a stock’s price is
falling or when the overall market is declining, loss aversion compels people to sell their
stocks. So instead of keeping their losses on paper and waiting for the market to change
directions, they accept a certain loss by selling. Such investor behavior is so widespread
that it affects the prices of individual stocks, exacerbating both upward and downward
market movements creating excessive moves.

Market Crashes
When the market reaches an unbelievable high, it usually results in a bubble. But
because the levels are unsustainable, investors end up panicking, leading to a massive
selloff. This results in a market crash. That's what happened in the early 2000s with the
dotcom bubble, when the values of tech stocks shot up beyond what the companies were
worth. We saw the same thing happened when the housing bubble burst and the market
crashed in the mid-2000s.

Unnoticed and Unglamorous Stocks

Look beyond what you're hearing in the news. You may find really great investment
opportunities in undervalued stocks that may not be on people's radars like small caps
or even foreign stocks.Most investors want in on the next big thing such as a technology
startup instead of a boring, established consumer durables manufacturer. For example,
stocks like Facebook, Apple, and Google are more likely to be affected by herd-
mentality investing than conglomerates like Proctor & Gamble or Johnson & Johnson.

Bad News

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Even good companies face setbacks, such as litigation and recalls. However, just
because a company experiences one negative event doesn’t mean that the company isn’t
still fundamentally valuable or that its stock won’t bounce back. In other cases, there
may be a segment or division that puts a dent in a company's profitability. But that can
change if the company decides to dispose of or close that arm of the business.

Analysts do not have a great track record for predicting the future, and yet investors
often panic and sell when a company announces earnings that are lower than analysts’
expectations. But value investors who can see beyond the downgrades and negative
news can buy stock at deeper discounts because they are able to recognize a company's
long-term value.

Cyclicality​
Cyclicality is defined as the fluctuations that affect a business. Companies are not
immune to ups and downs in the economic cycle, whether that's seasonality and the
time of year, or consumer attitudes and moods. All of this can affect profit levels and
the price of a company's stock, but it doesn't affect the company's value in the long
term.

Value Investing Strategies

The key to buying an undervalued stock is to thoroughly research the company and
make common-sense decisions. Value investor Christopher H. Browne recommends
asking if a company is likely to increase its revenue via the following methods:

Raising prices on products

Increasing sales figures
Decreasing expenses
Selling off or closing down unprofitable divisions

Browne also suggests studying a company's competitors to evaluate its future growth
prospects. But the answers to all of these questions tend to be speculative, without any
real supportive numerical data. Simply put: There are no quantitative software
programs yet available to help achieve these answers, which makes value stock
investing somewhat of a grand guessing game. For this reason, Warren Buffett
recommends investing only in industries you have personally worked in, or whose
consumer goods you are familiar with, like cars, clothes, appliances, and food.

One thing investors can do is choose the stocks of companies that sell high-demand
products and services. While it's difficult to predict when innovative new products will
capture market share, it's easy to gauge how long a company has been in business and
study how it has adapted to challenges over time.

Insider Buying and Selling

For our purposes, insiders are the company’s senior managers and directors, plus any
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shareholders who own at least 10% of the company’s stock. A company’s managers and
directors have unique knowledge about the companies they run, so if they are
purchasing its stock, it’s reasonable to assume that the company’s prospects look
favorable.

Likewise, investors who own at least 10% of a company’s stock wouldn’t have bought so
much if they didn’t see profit potential. Conversely, a sale of stock by an insider doesn’t
necessarily point to bad news about the company’s anticipated performance — the
insider might simply need cash for any number of personal reasons. Nonetheless, if
mass sell-offs are occurring by insiders, such a situation may warrant further in-depth
analysis of the reason behind the sale.

Analyze Earnings Reports

At some point, value investors have to look at a company's financials to see how its
performing and compare it to industry peers.

Financial reports present a company’s annual and quarterly performance results. The
annual report is SEC form 10-K, and the quarterly report is SEC form 10-Q. Companies
are required to file these reports with the Securities and Exchange Commission (SEC).
You can find them at the SEC website or the company’s investor relations page on their
website.

You can learn a lot from a company’s annual report. It will explain the products and
services offered as well as where the company is heading.

Analyze Financial Statements

A company’s balance sheet provides a big picture of the company’s financial condition.
The balance sheet consists of two sections, one listing the company’s assets and another
listing its liabilities and equity. The assets section is broken down into a company’s cash
and cash equivalents; investments; accounts receivable or money owed from customers,
inventories, and fixed assets such as plant and equipment.

The liabilities section lists the company’s accounts payable or money owed, accrued
liabilities, short-term debt, and long-term debt. The shareholders’ equity section
reflects how much money is invested in the company, how many shares outstanding,
and how much the company has as retained earnings. Retained earnings is a type of
savings account that holds the cumulative profits from the company. Retained earnings
are used to pay dividends, for example, and is considered a sign of a healthy, profitable
company.

The income statement tells you how much revenue is being generated, the company's
expenses, and profits. Looking at the annual income statement rather than a quarterly
statement will give you a better idea of the company’s overall position since many
companies experience fluctuations in sales volume during the year.

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Studies have consistently found that value stocks outperform growth stocks and the
market as a whole, over the long-term.

Couch Potato Value Investing

It is possible to become a value investor without ever reading a 10-K. Couch potato
investing is a passive strategy of buying and holding a few investing vehicles for which
someone else has already done the investment analysis—i.e., mutual funds or exchange-
traded funds. In the case of value investing, those funds would be those that follow the
value strategy and buy value stocks—or track the moves of high-profile value investors,
like Warren Buffet. Investors can buy shares of his holding company, Berkshire
Hathaway, which owns or has an interest in dozens of companies the Oracle of Omaha
has researched and evaluated.

Risks with Value Investing

As with any investment strategy, there's the risk of loss with value investing despite it
being a low-to-medium-risk strategy. Below we highlight a few of those risks and why
losses can occur.

The Figures are Important

Many investors use financial statements when they make value investing decisions. So if
you rely on your own analysis, make sure you have the most updated information and
that your calculations are accurate. If not, you may end up making a poor investment or
miss out on a great one. If you aren’t yet confident in your ability to read and analyze
financial statements and reports, keep studying these subjects and don’t place any
trades until you’re truly ready. (For more on this subject, learn more about financial
statements.)

One strategy is to read the footnotes. These are the notes in a Form 10-K or Form 10-Q
that explain a company’s financial statements in greater detail. The notes follow the
statements and explain the company’s accounting methods and elaborate on reported
results. If the footnotes are unintelligible or the information they present seems
unreasonable, you’ll have a better idea of whether to pass on the stock.

Extraordinary Gains or Losses

There are some incidents that may show up on a company's income statement that
should be considered exceptions or extraordinary. These are generally beyond the
company's control and are called extraordinary item—gain or extraordinary item—loss.
Some examples include lawsuits, restructuring, or even a natural disaster. If you
exclude these from your analysis, you can probably get a sense of the company's future
performance.

However, think critically about these items, and use your judgment. If a company has a
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pattern of reporting the same extraordinary item year after year, it might not be too
extraordinary. Also, if there are unexpected losses year after year, this can be a sign that
the company is having financial problems. Extraordinary items are supposed to be
unusual and nonrecurring. Also, beware of a pattern of write-offs.

Ignoring Ratio Analysis Flaws

Earlier sections of this tutorial have discussed the calculation of various financial ratios
that help investors diagnose a company’s financial health. There isn't just one way to
determine financial ratios, which can be fairly problematic. The following can affect
how the ratios can be interpreted:

Ratios can be determined using before-tax or after-tax numbers.

Some ratios don't give accurate results but lead to estimations.
Depending on how the term earnings are defined, a company's earnings per share
(EPS) may differ.
Comparing different companies by their ratios—even if the ratios are the same—
may be difficult since companies have different accounting practices. (Learn more
about when a company recognizes profits in Understanding The Income
Statement.)

Buying Overvalued Stock

Overpaying for a stock is one of the main risks for value investors. You can risk losing
part or all of your money if you overpay. The same goes if you buy a stock close to itsfair
market value. Buying a stock that's undervalued means your risk of losing money is
reduced, even when the company doesn't do well.

Recall that one of the fundamental principles of value investing is to build a margin of
safety into all your investments. This means purchasing stocks at a price of around two-
thirds or less of their intrinsic value. Value investors want to risk as little capital as
possible in potentially overvalued assets, so they try not to overpay for investments.

Not Diversifying
Conventional investment wisdom says that investing in individual stocks can be a high-
risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that
we have exposure to a wide variety of companies and economic sectors. However, some
value investors believe that you can have a diversified portfolio even if you only own a
small number of stocks, as long as you choose stocks that represent different industries
and different sectors of the economy. Value investor and investment manager
Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book
of Value Investing.” According to Benjamin Graham, a famous value investor, you
should look at choosing 10 to 30 stocks if you want to diversify your holdings.

Another set of experts, though, say differently. If you want to get big returns, try
choosing just a few stocks, according to the authors of the second edition of “Value
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Investing for Dummies.” They say having more stocks in your portfolio will probably
lead to an average return.Of course, this advice assumes that you are great at choosing
winners, which may not be the case, particularly if you are a value-investing novice.

Listening to Your Emotions

It is difficult to ignore your emotions when making investment decisions. Even if you
can take a detached, critical standpoint when evaluating numbers, fear and excitement
may creep in when it comes time to actually use part of your hard-earned savings to
purchase a stock. More importantly, once you have purchased the stock, you may be
tempted to sell it if the price falls. Keep in mind that the point of value investing is to
resist the temptation to panic and go with the herd. So don't fall into the trap of buying
when share prices rise and selling when they drop. Such behavior will obliterate your
returns. (Playing follow-the-leader in investing can quickly become a dangerous game.

Example of a Value Investment

Value investors seek to profit from market overreactions that usually come from the
release of a quarterly earnings report. As a historical real example, on May 4, 2016,
Fitbit released its Q1 2016 earnings report and saw a sharp decline in after-hours
trading. After the flurry was over, the company lost nearly 19% of its value. However,
while large decreases in a company's share price are not uncommon after the release of
an earnings report, Fitbit not only met analyst expectations for the quarter but even
increased guidance for 2016.

The company earned $505.4 million in revenue for the first quarter of 2016, up more
than 50% when compared to the same time period from one year ago. Further, Fitbit
expects to generate between $565 million and $585 million in the second quarter of
2016, which is above the $531 million forecasted by analysts. The company looks to be
strong and growing. However, since Fitbit invested heavily in research and
development costs in the first quarter of the year, earnings per share (EPS) declined
when compared to a year ago. This is all average investors needed to jump on Fitbit,
selling off enough shares to cause the price to decline. However, a value investor looks at
the fundamentals of Fitbit and understands it is an undervalued security, poised to
potentially increase in the future.

The Bottom Line

Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with
the intention of holding them almost indefinitely. He once said, “I never attempt to
make money on the stock market. I buy on the assumption that they could close the
market the next day and not reopen it for five years.” You will probably want to sell your
stocks when it comes time to make a major purchase or retire, but by holding a variety
of stocks and maintaining a long-term outlook, you can sell your stocks only when their
price exceeds their fair market value (and the price you paid for them).

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