Value investing: The Definitive Guide

Value Investing

Written by Aryan Agarwal

June 9, 2020

Price is what you payValue is what you get.

Warren Buffet

Once you know how to make a brokerage account and you decide to start investing, you need to know how to pick stocks to invest in.

Value investing is one of the best techniques to learn about how to pick stocks. It’s so amazing that Mr Warren Buffet uses it. He is the world’s most famous and richest investor.

You can learn to invest like him using value investing

You can download an excel template as well that will reduce your work while calculating the intrinsic value. More of that later.

What is Value Investing?

Value investing is a technique of picking wonderful stocks that are trading below their fair or intrinsic value.

Value investing is based on making decisions based on fundamental analysis and deciding what the intrinsic value of the company is and forget what everyone else is saying.

It is essentially a buy and holds strategy where you buy a company and hold it for long periods of time like minimum 10-15. It pays attention to stock market overreactions to specific events that are happening and to companies which pay dividends.

Benjamin Graham, the mentor of Mr Warren Buffet, is considered to be “The Father of Value Investing”. He is also the author of The Intelligent Investor.

Benjamin Graham said that “Value Investing is Intelligent Investing” in his book The Intelligent Investor. He says that in value investing, you need to perform a complete and in-depth analysis before investing your money in any company. Doing this will give you safe and steady returns.

The Intelligent Investor will also focus on pricing as they will buy a stock only when the price of the stock is lower than the intrinsic value of the company.

He went further and said that the intelligent investor will always look for a margin of safety (MOS) before buying a stock. This means that you buy a stock only if the price is considerably (around 50%) lower than the intrinsic value.

Value Investing

‘Value Stocks’: Historical Returns

Bank of America Merrill Lynch performed a study and found that between 1926 to 2016, value stocks returned 17% compound annual growth rate (CAGR) compared to 12.6% CAGR returned by growth stocks.

Essential Terms to Know

Before we dive deeper into value investing, you should be familiar with all the basic terminology that will be mentioned in the article.

Intrinsic value

Intrinsic value, also known as a fundamental value is the real worth of the stock. Company’s stock prices react to fundamental factors such as financial performance, product momentum, the strength of its brand, executive team, etc. and several external factors like macroeconomics and geopolitics, which are out of companies control.

Therefore, fundamental value attempts to eliminate the influence of these external factors and focus only on the fundamentals, as that’s the thing that solely determines the money available to the stockholders.

It is calculated by various rules such as Discounted Cash Flow Analysis, Dividend Discount Model, Ben Graham No., Rule #1, etc.

Intrinsic Value

Margin of Safety

The margin of safety is the difference between the market price of the stock and its intrinsic value. A higher margin of safety is better as it cushions you against bad decisions.

Margin of Safety

Discounted Cash Flow

Discounted Cash Flow (DCF) is a valuation method where we can calculate the present value of a stock by discounting the estimated future cash flow the company will generate using an appropriate discount rate to determine the fundamental value of the company.

Dividend Discount Model

Dividend Discount Model (DDM) is a valuation method like DCF. Still, instead of using future cash flow, we use future estimated dividend and discount it to its present value.

PEG Ratio

Price/Earnings to Growth Ratio (PEG Ratio) is a stock’s price to earnings (P/E) ratio divided by the growth rate of its earnings for a particular time period. The PEG ratio is used to determine the value of the stock while also factoring in the company’s growth potential.

It gives a complete picture than the ore standard P/E ratio of the company because when a company is growing faster, it will have a higher P/E. These companies look costly through P/E but will be better represented by the PEG ratio.

Any company whose PEG ratio is below 1 is considered to be potentially undervalued. In contrast, PEG over 1 is considered to be overvalued.

PE Ratio

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.

PE ratio is used by investors to determine the relative value of a company’s stock relative to other companies. P/E ratio can also be used to compare a company against its own historical record or the aggregate markets against one another or over time.

Ben Graham Number

Ben Graham Number is a figure that measures a stock’s fundamental value by taking into account the company’s EPS and book value (BV) per share. It is the upper bound price range that a defensive investor should pay for the stock.

Any price below Ben Graham Number is considered to be undervalued and thus worth investing in.

The formula is:

Ben Graham Formula

Rule #1

Rule #1 Method is a modification of value investing by Phil Town. In this method, while working for companies and their financials, you also need to look for their moat and management. We will discuss Rule #1 Method in detail later in this article.

Benjamin Graham Original Strategy

Ben Graham used to look for potentially undervalued companies that were public and tradable.

Fundamentals of Value investing

Research

Analyze a company’s financials before investing any money in them. You should be able to understand its long-term plans, business principles, financial structure and management.

Value investing even focuses on dividend-paying companies because they are mature and profitable companies they often pay out part of their profits back to the stockholders.

Intelligent investors always look past the short-term view of a company and always focus on the long term.

Diversification

Diversification is vital in every stock market investing strategy because you don’t want to be invested in a single company only to see it fail.

It’s just like the famous quote “Don’t put all your eggs in a single basket”.

Diversification protects you from any severe losses.

Safe and Steady Returns

Ben Graham and Warren Buffet prefer to invest in a company with a boring business model instead of companies that you see in the news daily. That’s because these companies will continue to grow for a long time instead of the hyped thing.

Whenever you read about a “HOT STOCK”, it’s already too late to invest in it as its well over its intrinsic value by then.

You might be able to earn money in the hot stocks, but it won’t last long; hence it is short term. We want to find something for the long term returns consistently. Therefore, we need to find low risk, consistent returns on our investments, year after year.

Original Value Investing Strategy

Warren Buffet used to find companies that had their book value more than the market cap of the company. He used to call it the ‘last puff of cigarette puff strategy’. This was the original value investing strategy by ben graham.

When he was just starting out in the 1950s, he used this based on value investing and earned a lot of money. He even said that when you are starting out, you can make a lot of money this way but also admitted it wasn’t a long-term strategy when you have a lot of money.

Buffet mentioned this experience in his 2014 Berkshire Hathaway Shareholders letters:

“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:

Cigar-butt investing was scalable only to a point. With large sums, it would never work well.”

Warren Buffet

Around that time, he found Charlie Munger, a student of Philip Fisher. Charlie taught Buffet that it’s not important to find any company at a lower price but it’s important to find wonderful companies at a fair price.

Buffet, therefore, modified his investing strategy since then and what he uses now is generally considered the right value of value investing.

Buffet recommends using the original strategy for small investors.

3 Points Buffet said for Small Investors

Select Classic Graham Type Stocks

Buffet said “When I had been working with a little amount, I surely would be more likely to check one of, what you could call the traditional Graham stocks “

Buffett confessed he will be more inclined to put money into Benjamin Graham’s stock-picking fundamentals. These stocks are generally small businesses, in sexy companies and might even have issues connected. That can be a far cry from the large, glamorous companies with an aggressive advantage that Buffett has been famous for investment in.

Small Investors have more Advantage

Buffet said, “I’d do much superior percentage-wise when I’m working with small amounts, there are simply way too many chances.”

The best way to use Graham’s strategy was that Buffett will have the ability to acquire a higher percent profit, than that he would when he stuck with all the huge businesses, he generally stinks in. There are a whole lot of more small businesses he could purchase and generate income. However, he can’t economically invest in tiny businesses when his funds became much bigger.

Small investors should diversify

I bought a large number of stocks in small amounts, in companies whose names I couldn’t pronounce. But the stocks as a group were so cheap, you have to make money out of it, it was Graham’s kind of stocks.

Warren Buffet

Graham’s principle was supposed to invest modest amounts in several businesses. It does not matter what companies they’re in as you don’t have to perform a detailed study. In Buffett’s voice, he did not even understand how to pronounce those titles, or what the firms did. Because of a high number of shares, it’s no longer matters in case some of these firms eventually go bankrupt, but there’ll be a few winners who could more than pay for the losses. As a set, or even as a part of shares, it could be a general advantage for your Graham investor.

Characteristics of Value Investing

Irrational Market

We think that the industry consists of irrational investors. Hence, prices on the stock market don’t accurately reflect the true value of a stock exchange.

A stock may be underpriced or overpriced, mainly owing to its investors’ sentiments.

And that generates chances for value investors who look to invest in undervalued stocks.

Intrinsic Value

As value investors, we feel that each stock has its own intrinsic value. This is the worth of this inventory. Also, it isn’t related to the cost it is currently trading at.

We plan to search for stocks that are trading at a price below its intrinsic value. Pretty similar to going into a store to search for things sold at a deal.

If our study and evaluation have been done right, there is a chance for its stock price to climb to its intrinsic value with time.

There is risk involved in any type of investing. It is not any different in Value Purchasing. No matter how in-depth your analysis will, you cannot guarantee a stock’s price will move in how that you’d call it too.

Due to point #1, a few shares’ true worth will only never have realized on the stock market.

Hence to reevaluate our potential reduction, value investors always search for a margin of safety (MOS); which is determined by the difference between its intrinsic worth and its current cost in the market.

Margin of Safety

There’s risk involved in any sort of investing. It’s not any different in Value Purchasing.

However, in-depth your investigation will, you cannot guarantee a stock’s price will proceed in how that you’d call it too.

Due to stage #1, a few shares’ true worth will only never have realized over the stock exchange.

Therefore, to reevaluate our possible reduction, worth investors always search for a margin of safety; that is dependent on the gap between its intrinsic worth and its current cost on the marketplace.

By way of instance, Benjamin Graham has been known to simply invest in stocks which were trading in 2/3 of the inherent worth.

Time and Effort

All value investors that wish to succeed in value investing has to be ready to devote some time and energy.

To ascertain a stock’s intrinsic value, value investors execute analysis according to their approach. This process demands effort and time (and more patience and nerves).

Many value investors make usage of fundamental factors to evaluate stocks, and there are little to no good basic stock screeners available. Even with a stock screener, value investors would still need to carry out their own due diligence to look past the numbers.

The marketplace is irrational. It might take some time for a stock’s true value to be realized in the stock exchange. A value investor might need to wait for months or years ahead of the inventory might realize its true worth to get a positive return.

The waiting period to get a positive ROI is something which most ordinary investors find hard to adhere to.

Contradiction

As previously mentioned, the market is irrational, and it’s driven by investors’ sentiments. This means that the price tag you see about the stock market and the performance of the stock at the marketplace reflect how investors feel about the stock.

Value investors tend not to generate investment decisions according to what everybody else is doing. In fact, we feel you have to be a contrarian to succeed because of a value investor.

Plus, it’s not simple.

This procedure can be eased if you’ve got a plan with clear buying and selling guidelines.

Value Investing as We Know It Today

Warren buffet after meeting Charlie Munger changed his value investing strategy from cigarette butt strategy to something like Rule #1 strategy.

Warren Buffet has never specifically mentioned how he picks his stocks. Still, from his speeches and letters to the shareholders, his strategy is pretty close to Rule #1 investing.

Rule #1 Investing

Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1“.

Warren Buffet

Rule #1 Investing term was popularized by investor and author Phil Town.

Phil Town said that to invest like Warren Buffet, you need to follow a strategy based on 4M which stands for

Meaning

It means that you need to have a complete understanding of the underlying business of the company and preferably have an emotional connection with the company as well, although the emotional connection is optional.

Understanding the company’s underlying businesses are crucial to Rule #1 investing as it requires you to predict the company’s future based on your understanding of the company.

You can learn all about a company’s business and how it earns its money from the company’s annual return which explains everything you would need to know in a company like the business it is involved with, the revenue breakdown as well as other things.

Moat

Moat means that the company must have a competitive advantage over other company in their respective industry and competing companies.

This moat will protect this company from future attacks on the company as it has something crucial that the other company doesn’t have.

 There are a lot of types of moats that a company can have. The best-known moat out there is Brand moat where a company has made a brand, and because of that, they can charge higher for their products. 

Best example out there is Apple by far. By far it has the best Brand moat known to the industry.

Other types of moats are secrets moat, switching moat, price moat and toll bridge moat. To check out more about these moats, you can check the article by Phil Town.

Management

You need to be sure that the management of the company has the right future in mind and want to achieve that for the company that you own. They should not be there to just fill their pockets with cash.

Instead, they should make their decisions for the company that will be beneficial in the long term and not for the short term where they can earn money by the stock options they receive.

Finding out if the management is component enough is one of the toughest tasks in Rule #1 investing strategy.

You can check the performance of the company under the management’s leadership and check out their interviews from news outlets if they have appeared on any. These things are a good way to start when you research.

Margin of Safety

As explained earlier, the margin of safety is when you buy a stock lower than its intrinsic value. In Rule #1 investing, minimum 50% margin of safety is required and quite frankly, it makes a lot of sense.

Even if you are wrong about the future of the company, because you bought it at such a discount, you end up making off it as well.

Having a margin of safety is always good irrelevant of the investing style and the higher margin of safety you can get, the higher profit chances you will have.

After finding all these things, it’s just a game of patience where you wait for the price to come to your desired margin of safety price.

You can learn all about Rule #1 Investing by Phil Town himself and get his book by the name of Rule #1 Investing.

Other Value Investing Strategies that You Can Use

Value investing is a large category, and a lot of investors have and use different valuation methods that they might have come up with. Most of the time, the different valuation methods do not agree on the intrinsic value.

However, each valuation methods has its pros and cons.

You, as value investors, should be well equipped with different valuation methods before deciding about sticking with 1 method and not change it afterwards.

Net-Net Strategy (Ben Graham’s Strategy)

Benjamin Graham invested during the dark days of the great depression where many companies were going bankrupt daily. To enhance his possibility of success in the stock market, the Net-Net strategy was designed with a focus on safety.

Graham had to ensure that even if the company he invested in were to go bust, he would still ‘win’ and make money. He looked for companies with excess liquid assets that could cover all their liabilities and still payout to their shareholders, even if they were to go bust. Hence Graham used ‘current assets’ instead of ‘total assets’ when looking for Net-Net stocks.

With that in mind, the value of a Net-Net stock is determined by this formula:

You would want to take profit once your gains hit 50% or cut loss after 2 years regardless of the stock price.

Some features of Net-Net stocks are:

  • Unfamiliar stocks: As they are unfamiliar, most investors shun them. Hence, they tend to be undervalued.
  • Low liquidity: Insufficient sellers too, hence discourage buyers from participating.
  • Small company: Most Net-Net stocks are small companies, and investors generally view them as risky. However, some of them could be debt-free and financially stronger than bigger companies.
  • Problems: Net-Net stocks are usually companies which are facing short term issues that lead to a drop in their prices. Once the issue is resolved, we would expect the stock price to increase.

Net Net Strategy Formula

Net Asset Value (NAV) valuation

The Net Asset Value (NAV) method is less conservative compared to Graham’s Net-Net Strategy. Nav or the book value is commonly used by many investors to get an idea of a company’s worth.

Net Asset Value of a stock can be determined by the following formula:

NAV-Method

Discounted Cash Flow (DCF) Valuation

With the DCF method, investors discount future cash flow projections to get an estimated present value of a stock

You can check out this video from ‘Learn to Invest’ YouTube channel

https://www.youtube.com/watch?v=fd_emLLzJnk

Get the DCF Valuation Template used in the video to calculate the shares you want to.

PEG Ratio (Peter Lynch’s Investing Strategy)

Made popular by Peter Lynch, author of the book ‘One Up on Wall Street’. This valuation is useful for growth stocks.

Peter Lynch mentioned that “The P/E Ratio of any company that’s fairly priced will equal to its growth rate.”

The P/E to growth (PEG) ratio is depicted as:

PEG

Pros of Value Investing

  • With value investing, you’re taking a look at a non-risk-high reward situation, as a drawback in an undervalued stock is restricted, reducing the dangers connected with that. But once the stock climbs toward its own inherent worth, the yields could be shocking.
  • Investors do not need to be worried about the daily changes in stock prices, because value investing concentrates on principles rather than extraneous elements that cause these changes.
  • Value investing requires psychological decision making (which always contributes to mistakes in investment choices) from the equation. Psychological conclusions are based on gut feeling or basic market conditions, although at value investing. You’re concentrating on stocks of businesses with strong growth potential and effective at providing excellent returns in the long term. In the procedure, you’re discounting the brief term setbacks.
  • Since value investment includes a longer-term horizon, so you have to cover a reduced tax rate in your investment earnings.
  • Because it is long term and not active trading, you spend less by means of commission and fees, provided you don’t transact often, but use a buy-and-hold plan.

Cons of Value Investing

  • The underperformance of stocks may persist for a longer duration, much like the distress of an investor that chose it up at the pretext of a value purchase.
  • It might require effort and time to perform analysis and research to select a value stock.
  • Calling a bottom is a challenging proposition, which makes it hard for identifying the ideal entry point.
  • Liquidity is frequently a concern with value purchases, given that their gloomy valuation.
  • It’s tricky to attain diversification with value purchases, exposing an investor to important dangers.

Growth Vs Value Stocks (What to Invest In)

Growth stocks are the companies that have better than average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth, although there are no guarantees. The key characteristics of growth funds are:

  • Higher P/E than the broader market

Investors are willing to pay higher for growth stocks because the investment will pay them back sooner than the broader market. They have the expectations of selling it at a high P/E as well.

  • Higher earnings growth

Growth stocks have higher earnings record, and some growth stocks can even withstand an economic downturn and continue to give high returns on the investments.

  • More volatile than broader markets

Growth stocks are considerably volatile compared to the stock market because any news can affect the price of the stock by quite a lot. The stock can drop like a brick if the company doesn’t meet the earnings expectation by the analysts.

Value stocks are companies that have fallen out of favor but still have good fundamentals. The key characteristics of value stocks are:

  • Lower price than the broader market

Value stocks are believed to be good companies that will bounce back in time if and when the true value is recognized by other investors.

  • Price below similar companies in the industry

Value stocks are created due to overreaction by investors to recent company troubles, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the company’s long-term prospects.

  • Carry somewhat less risk than the broader market

Value stocks are more suited to long term investors and carry less risk of price fluctuations than growth stocks

So What’s Better

I can’t decide your investing strategy because its different for everybody based on their risk tolerance and investing habits.

Studies show that value investing has outperformed growth stocks over extended periods of time on a value adjusted basis. That doesn’t mean that growth investing is not worth it.

Ideally, your portfolio must consist of a somewhat combination of growth and value investments at the beginning of your investment portfolio. Still, you can select which strategy you are comfortable with and stick with it.

Case Study

This is a case study about investing in ‘Whole Foods’ by Phil Town Himself.

He invested in Whole Foods because he liked the founder and his commitment to the company. The fact that Whole Foods was the industry leader in their category as they sort of invented the category.

You can check out his video explaining the process of his selection

https://www.youtube.com/watch?v=m8pw3ytTMic&list=PLymlUHMR5BXhqoT8rCNWlFz8Z_lVjnd_n

Best Resources and Books for Value Investing

Stock Screeners

Stock Screener India

https://www.screener.in/

By far the best stock screener I have used. Finding undervalued companies or growth stocks, all can be done using this screener. 

They have an export to excel feature where you can make a template and use that for every stock you want to analyze.

This eliminates the need to input values in your template and its a streamlined process. You can use this feature by registering and simply uploading the template, so the next time you’ Export to Excel’ for any stock, the website will automatically fill the data and give it to you.

Acquirer’s Multiple

http://acquirersmultiple.com/

Deep Value Stock Screener. Find undervalued activist and takeover targets.

FINVIZ

http://finviz.com/screener.ashx

Stock screener for investors and traders, financial visualizations.

GuruFocus

http://www.gurufocus.com/screener/

The All-in-One Guru Stock screener. The screener has more than 120 filters for you to screen your favorite stocks.

Books

Conclusion

Value investing is a proven strategy to build wealth. However, value investing is subjective and depends on your style of investing.

To be a successful value investor, you will have to continuously research and analyze stocks to determine the best stocks.

This can take a lot of work but can get pretty good returns without considerable risk, thus building wealth.

You can download the investing template for screener.in if you are from India, which contains all the investing methods we discussed in this article and more.

If you are not from India, I have got you covered, and you can get the DCF and Rule #1 excel templates where you can put the values to get the intrinsic value.

Frequently Asked Questions(FAQs)

What is Value Investing?

Value Investing

Value investing is a technique of picking wonderful stocks that are trading below their fair or intrinsic value.
Value investing is based on making decisions based on fundamental analysis and deciding what the intrinsic value of the company is and forget what everyone else is saying.
It is essentially a buy and holds strategy where you buy a company and hold it for long periods of time like minimum 10-15. It pays attention to stock market overreactions to specific events that are happening and to companies which pay dividends.
Benjamin Graham, the mentor of Mr Warren Buffet, is considered to be “The Father of Value Investing”. He is also the author of The Intelligent Investor.
Benjamin Graham said that “Value Investing is Intelligent Investing” in his book The Intelligent Investor. He says that in value investing, you need to perform a complete and in-depth analysis before investing your money in any company. Doing this will give you safe and steady returns.
The Intelligent Investor will also focus on pricing as they will buy a stock only when the price of the stock is lower than the intrinsic value of the company.
He went further and said that the intelligent investor will always look for a margin of safety (MOS) before buying a stock. This means that you buy a stock only if the price is considerably (around 50%) lower than the intrinsic value.

Why should you select value investing?

Bank of America Merrill Lynch performed a study and found that between 1926 to 2016, value stocks returned 17% compound annual growth rate (CAGR) compared to 12.6% CAGR returned by growth stocks.
Furthur, Warren Buffet also uses this strategy to invest his money.

What strategy does Warren Buffet use?

Warren Buffet uses Value Investing

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4 Comments

  1. Prianca Mishra

    Very informative, keep going!

    Reply
  2. Aryan Agarwal

    Thank You So Much Prianca for the support!

    Reply
  3. Jamie

    This is a fantastic guide to value investing! I’ve read a lot of books on Warren Buffet and value investing – including the famous “The Intelligent Investor” by Benjamin Graham, Warren Buffet’s first mentor – but I decided against that style for me because of the amount of research work involved. If I had the time, I would go for this strategy over growth stocks or dividend investing.

    Reply
    • Aryan Agarwal

      Ya, it can be a bit time consuming, but if you can build a routine and only analyze a company you understand, you could shave off a lot of time.

      Reply

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