Value Investing: The Art of Buying Undervalued Companies

11 minutes

 

“Price is what you pay, value is what you get.”

Warren Buffett

In this simple saying, Warren Buffett, arguably the greatest investor of our generation has summed up what value investing is. It is the search for companies that are selling below their intrinsic value, with the hope that we can buy them at a discount and that their price will rise over time.

Value investing, unlike some other investing strategies is fairly simple. It doesn’t require that you have an extensive background in finance. Certainly, understanding the basics of finance will help, but you don’t need to go to Harvard to follow this strategy.

It also doesn’t require an expensive subscription to terminals to help you find companies or how to read very extensive charts. There is also little need for math, but some is required.

The main ingredients needed are patience, common sense, money to invest and the willingness to do some reading and accounting then you have what it takes to become a value investor.

Five Fundamental Concepts of Value Investing

Value Investing Fundamental No. 1 – All companies have intrinsic value. This is what gets most people about value investing. The basic concept is so simple that you probably do it on a daily basis already. The idea is that if you already know the true value of something then you will save a ton of money by buying it when it is on sale.

Let’s use an example to illustrate. Most people would agree that whether you buy a new cell phone when it’s on sale or when it’s at full price, you’re getting the same cell phone with the same screen size and same memory. The obvious assumption that we have to make is that the value of the cell phone will not depreciate with time as new technology becomes available.  

Stocks are the same way, the company’s stock price can change even though it’s intrinsic value has stayed the same. Stocks, like cell phones, go through periods of higher or lower demand. These fluctuations change the price but they don’t change what you are getting.

Most savvy shoppers would say that it is crazy to buy a cell phone at full price when you can buy them on sale many times throughout the year, particularly during the holidays. Stocks work the same way. The only difference is that unlike cell phones, there is no predictable time of the year that stocks will go on sale, such as a Black Friday event. Which is unfortunate. Also, their prices won’t be advertised in a daily mailing like Target. Also unfortunate.

If they did know about the sale price it would create more demand and drive up the price, which means they wouldn’t be a bargain for us to take advantage of.

The trick with value investing, if you are willing to do a little sleuthing work to find these secret sales, you can get stocks at a discount that other investors would be oblivious to.

Value Investing Fundamental No. 2 – Always have a margin of safety. Buying companies at bargain prices always give you a better chance of making a profit when you sell them later on.  

This also helps you lessen the loss if the price fluctuates over time. Value stocks tend to have less volatility than other stocks, but this is a generality as there is no guarantee in the stock market.

The margin of safety is one of the main tenets of value investing and it was first created by Benjamin Graham. At its core, it states that you buy a company that is trading for less than what it is worth. This is referred to intrinsic value. As the price of the company rises you have your margin of safety. If at any time the price falls you still won’t lose any money. Warren Buffett stated famously that he had two rules.

“Rule number one is to never lose money, and rule number two is to never forget rule number one.”

Having a margin of safety gives you the ability to follow this rule. Benjamin Graham, who was Warren Buffett’s mentor was a strong believer of this axiom. He discovered during the aftermath of the Great Depression that there were companies that were significantly overvalued and that some of the extreme losses could have been avoided by staying away from these overvalued companies.

You can look at margin of safety as buying stocks that are on sale. This is something that we do in our daily lives. Let me give you an example. A lot of people like to buy clothes on sale, for many reasons such as maybe you won’t like it’s fit or color once you get it home. If you buy the shirt on sale for $15 and it normally sells for $40 then your margin of safety would be $15. This is what you would be willing to lose if you ended up not caring for the shirt. If you bought it for the original $40 you would have really felt burned. Now if you really like the shirt and wore it hundreds of times then you would have gleaned tremendous value from that shirt.

Of course one of the differences is that your shirt will never gain in value and when you sell it you won’t generate a profit.

This is a philosophy that value investors are probably best known for. They scour the stock market looking for companies that are selling for sale from their value. Remember that price doesn’t equal value.

Benjamin Graham looked for companies that were selling at 50% to 66% of a discount to their value. What every margin of safety you decide upon will be up to your risk tolerance.

If you are looking for a deeper look into this principle, please take a look at a guest post that I wrote for one of my favorite blogs, einvesting for beginners here.

Value Investing Fundamental No. 3 – The Efficient Market Hypothesis is wrong.  Value investors do not believe in the Efficient Market Hypothesis which states that stock prices already have everything known about them factored into the price.

This is patently false, as value investors believe very strongly that the market is anything but efficient. There are wild price swings on a constant daily occurrence.

A couple of examples illustrating this folly. Every day there rushes into and out of stocks based on fear of the particular company is doing poorly. Take the panic selling during the Great Recession recently when all the investors sold out of their positions because they feared the economy was doing poorly. Or on the opposite end of the spectrum, think of the greed that populated the market during the dot-com bubble when everyone sought to buy into the market because they didn’t want to miss out.

During each of the examples, the intrinsic value of these particular stocks didn’t alter much but the fear and greed drove the prices up or down.

Followers of Efficient Market Hypothesis believe that value investors like Warren Buffett, Charlie Munger, Benjamin Graham and Joel Greenblatt are just anomalies or simply lucky. They feel that it is impossible to beat the market because the prices are accurate to the information known. What it doesn’t take into account is human nature which drives the market, in many ways far more than knowledge will.

Warren Buffett gave a terrific speech during the 50th anniversary of the book, Security Analysis by Benjamin Graham in 1984. He gave this speech at Columbia Business School. In it, he outlined his thoughts on this Hypothesis and laid out his “Superinvestors of Graham and Doddsville” which he uses to debunk this Hypothesis. You can find the speech here.

This is a must read for any investor, whether or not you follow Warren Buffett or the value investing way. I did a breakdown of this awesome speech which you can find here.

The bottom line is that value investors believe that companies are going to be mispriced based on many different reasons and they are looking to take advantage of these mispricings to get a margin of safety on a wonderful business. If you could buy a brand new BMW for half of its price, why wouldn’t you? Of course, you would check it out to make sure it wasn’t stolen or have a mechanic take a look at it first. This is called doing your due diligence before buying. But once you determined it was good to go you would pull the trigger right away. In a nutshell, this is what value investing is.

Value Investing Fundamental No. 4 – Successful Investors don’t follow the herd. Value investors follow many characteristics of contrarians, people who don’t follow the herd. Value investors will often be the ones selling when others are buying, and buying when everyone else is selling. Again to quote Warren Buffett.

“We simply attempt to be fearful when others are greedy and to be greedy when others are fearful.”

Value investors typically don’t buy the biggest, most popular names in the stock market. Usually, because they are overpriced. Value investors will invest in companies that aren’t household names. If the financials check out. They will also take a look at household names. When the stock prices plummet. Value investors feel that companies that deliver valuable consumer products or services can recover from setbacks. Or downturns if their fundamentals remain strong.

They will jump on an Apple if the price stumbles because the market thinks they have fallen out of favor. And the fundamentals haven’t changed.

Think of the stock market as the herd that flocks to the new restaurant in town simply because it is the new shiny thing. As soon as the newness wears off. They are on the new next big thing. This is how the stock market works as well.

Recently when Facebook had their IPO. They were the new stock market darlings and the price skyrocketed. But months later it dropped like a rock. Because it was no long the new shiny thing. This is when a value investor would possibly take a look at the company. Because the fundamentals of the company wouldn’t have changed in those few months. It could have presented an opportunity to get into a company at a discount, which is where the value investor makes his money.

Human nature makes this one of the hardest fundamentals to adhere to. It takes a lot of will to ignore the herd. There is always the fear of missing out that makes us choose to ignore our instincts. And buy a stock even when we know it is a bad time or not the right price.

You will find that controlling your emotions is one of the most difficult challenges to value investing that you will find. This is what makes or breaks you when you follow this style of investing. If you struggle with the ups and downs of the market on a daily basis. Then investing might not be for you. We will discuss this more in future posts, but for right now to be a value investor means that you don’t follow the herd. You look for great companies at a discount to their intrinsic value and you buy when they fall into that zone. Simple, huh.

Value Investing Fundamental No. 5 – Investing requires diligence and patience. Value investing is for the long haul, it does not provide instant gratification. If you buy that stock for $40 on Monday you can’t expect to sell it for $100 on Friday, it just doesn’t work that way.

In fact, you might have to wait years to see a company’s price increase to the point where you will make money on your investment. Good news, the government taxes on long-term gains is less than short-term gains.

Value investing is a bit of an art form. As it encompasses more than just plugging numbers into a formula. And spitting out a number. There is diligence in looking at all aspects of the business. From the management to the types of products and services offered. Also to be considered is the economic situation of the time. To be sure there is math involved in this style. But there is more to looking at the whole package that the company has to offer.

On the diligence side of value investing will require quite a bit of detective work on your part. First to identify the company that may be a buying opportunity. Next is the looking into the financials of the company. To determine what a value may be placed on that particular company. This requires looking at the balance sheets, cash flow statements, and income statements. To determine how the money is being earned, used and spent.

Once this is done then you can determine what a fair value would be, then you can compare the value to the current price to help assess whether is a margin of safety.

Now is where patience comes into play. Because after you have done all the hard work to determine a price you would be willing to pay, you must be willing to wait for that stock to fall to that price so you can make your purchase.

As my wife tells me all the time, patience is one of life’s hardest virtues to master. It is natural to want instant gratification and it is only getting worse with our fast-food mentality. We want it all and we want it now.

In value investing you will have your patience tested. As you wait for the price of a company you really like to fall to a point where it is attractive enough for you to buy. But that patience will be rewarded tenfold over time.

With all the mood swings of the market, you will be tested as well because the price of you company that you’re interested in will dip and soar, but you must be patient while you wait for it to reach that price. And once you have purchased the company you will see it ebb and flow as well but you must faith that it will turn out in your favor.

This is why you spend so much time working to find a margin of safety to help guard against those drops that take your breath away. The margin of safety will help you sleep better at night because you know that you have helped minimize the chance of losing money on your investment.

Final Thoughts

Value investing is one of the best-performing styles of investing out there. Studies have shown that over the last 75 years value investing as taught by Benjamin Graham has outperformed the S&P during that time period.

It is a simple set of rules that anyone can follow, it does require some math and basic accounting fundamentals. But it is a style that can be followed by someone without any finance education.

Warren Buffett has mentioned several times in essays and speeches that he feels like this style is unquestionably the best. And that it usually takes with an investor right away or it never takes at all.

It does require some fortitude on your part in respects to the more emotional nature of our feelings. Patience and diligence are critical to this style of investing. Also being a contrarian is a plus when it comes to value investing.

Lastly, value investing is an art. In that, it brings many different disciplines to the fore when you take this type of investing to heart. And the funny thing is that it is part of our everyday life that we use constantly. Tell me about someone who isn’t looking for a deal on something that they value. And wouldn’t jump at the chance to buy that something when it was on sale. The larger the difference in sale price. And the bigger satisfaction we derive from the purchase.

The trick is to take that natural impulse and to apply the same attitude to your investments. I guarantee you will reap the benefits of this style of investing over time. If you follow the fundamentals that we have discussed.

As we wrap this up I want to leave with another Warren Buffett quote.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

That pretty much sums it up.

As always thank you for taking the time to read this post. I really do appreciate it.

Tell me thoughts on value investing? Have you ever bought something at a discount? Can you see how this would work in the stock market?

Take care,

Dave

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