Demystifying Value Investing: Answers to Your Top 4 Questions

By
A A A

We strongly believe value investing has an edge over other approaches in this kind of market, where hysterical market plunges open up unprecedented opportunities for deep-value investors. With the seesaw motions of the last few weeks, adopting the tenets of value investing is more important than ever.

Last year we conducted a survey on value investing. We compiled, categorized and ranked almost 2,000 responses from readers like you, and we're happy to present you with four of the most frequently asked questions about value investing...along with our answers.

1. What is "value investing," anyway?

Value investing is simply buying stocks that trade for less than they are really worth, i.e., their intrinsic value . Value investors look for stocks that they believe the market has undervalued. Since the market overreacts to bad news, a company's stock price can stray far from what the fundamentals would dictate. This gives value investors an opportunity to profit by buying when the price is deflated.

Keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and place no value on future growth. Other value investors include estimates of future growth and cash flows to come up with a number that a stock is "really" worth. Despite the different methodologies, it all comes back to trying to buy something for less than its true value.

Ben Graham is widely recognized as the father of value investing. Graham and Dodd's 1934 Securities Analysis was the ground-breaking work on buying companies based on intrinsic value of the business rather than price momentum, charting, or other technical analysis .

Graham produced annualized returns of better than +17% between 1934 and 1956 -- delivering a whopping 27-fold gain for his investors. And Warren Buffett, a student and former employee of Graham, has scored average annualized gains of more than +15% over the course of the last 40 years -- almost double the return delivered by the S&P 500.

Value investing is a contrarian approach that requires a strong understanding of balance sheets and other financial data. You have to be willing to crunch the numbers and make predictions that you are willing to risk money on. It isn't for the weak of heart. That being said, value investors who pick up cheap shares in bear markets can see massive triple-digit gains.

2. How does value investing stack up to other styles in terms of performance?
No other approach has proven to be more effective or reliable than value investing over the long haul.

A classic study by Ibbotson found that value stocks generated average annual returns of +11% over a 34-year period vs. just +6.5% for the S&P 500. Ten-thousand dollars invested in value stocks during this period would have grown to $347,521 vs. only $85,091 for the S&P 500 -- making the value stock investor more than four times richer than an investor who put his money in the S&P 500.

While momentum investors come and go, value investing has shown incredible staying power over the decades. Just run down any list of the most successful investors of all time. Virtually all of the names are value investors: Warren Buffett, Benjamin Graham, Peter Lynch, John Templeton, etc. While all these men certainly hit cold streaks, no other investment approach has proven to be more effective over the long haul than value investing.

By investing in companies selling below their fair market value , Buffett's Berkshire Hathaway portfolio produced an annualized return of about +15% from 1965 to 2009. That was enough to turn a $10,000 investment in the mid-1960s into more than $45 million!

3. I'm a retiree, so capital preservation is important to me. Are value stocks safe?
By their very nature as deeply discounted "on sale" securities, value stocks are safer than most other equities.

If you have a statistical bent, you can predict the volatility of your value stocks down to the decimal point. All you have to do is look up its beta or standard deviation (both measures of volatility) to see how stable it is before you buy it. You will almost always find that value stocks score better on these risk measures.

Value investing has its risks, but it's not roulette. If you pick the wrong stock, you don't lose as much as other investors because the stock is already scraping bottom.

If you follow the concepts of value investing and seek companies that have a strong financial footing but a depressed stock price, then your downside risk is mitigated and the risk of losing everything is tiny.

You also need to factor in a margin of safety for every stock you consider. This means buying at a big enough discount to allow some room for error in your estimation of value.

A value investment could make a substantial profit in a few weeks or it could languish for years before popping back. Value investing takes patience.

One of the best assets a value investor can have is a long memory. If you can remember a time when the business conditions were similar to this one, then you can go back and determine what happened to stock prices. For instance, when oil rises or falls, what usually happens to oilfield service providers? When recessions hit, what happens to food companies? Value investing is a rigorous intellectual pursuit: You've got to merge the data with the news and decide the degree to which you're willing to bet the outcome will be the same.

Because it's so rigorous, value investing is mentally and emotionally satisfying -- and a constant source of intellectual enrichment. What's more, everything value investors must learn can be applied to other methods of investing. Value investors, for instance, must do real research. They study. They play devil's advocate. They fiddle around with spreadsheets. All of this gives them an edge over investors who simply bought a stock they heard about on the news but really knew nothing about.

Most value investors learn that the first time one of their picks goes down. The fellow who bought because he heard about it on the news is upset because he moved into the losing column, but the value investor finds himself very pleased that the company's shares are on sale. That works in this environment and all others.

4. What are the keys to finding the best undervalued stocks?

There are many ways to find bargain stocks, and no single approach can be called "correct." Two investors can take the same information and come up with significantly different values on a company.

That said, here are five key factors we tend to use when evaluating cheap value stocks:

Discount pricing -- the stock must be selling at a -20% to -50% discount to the company's fair market value, giving us price appreciation potential as high as +100% . . . and we also like a stock to be selling substantially below its 52-week high.

Free cash flow ( FCF ) -- the companies should generate truckloads of cash flow . Their future cash flow-to-sales ratios should be above sector norms.

Return on invested capital ( ROIC ) -- ROIC should exceed the company's cost of capital to ensure that shareholder value is being created and not destroyed.

Return on equity ( ROE ) -- A high ROE indicates that management allocates its capital efficiently and does not spend recklessly to obtain growth.

Wide economic moats -- An "economic moat " is a market factor that helps defend the business from its competitors -- for instance, a pharmaceutical company with key patents on a particular class of drugs.

One thing is for sure: value investing requires work. You've got to roll up your sleeves and put on your reading glasses. The only way to make a sensible determination on a stock's "real" value is to read every bit of information you can get your hands on -- from the daily business papers to the weekly magazines. You need to keep your eyes on economic data and corporate trends and try to put what you hear and read into context with what you see in the pricing of equities.

To get inspriation from some of the world's greatest investors of all time, we highly recommend these other InvestingAnswers articles:  The Man Warren Buffett Dubbed a "Superinvestor" and Understanding the Four Pillars of Warren Buffett.

a:link {color:#125AD3; } a:visited {color:#125AD3;}
Nathan Slaughter

Editor:
Market Advisor
Half-Priced Stocks
The ETF Authority




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Personal Finance , Retirement

Referenced Stocks: FCF , ROE , ROIC

Investing Answers

Investing Answers

More from Investing Answers:

Related Videos

Stocks

Referenced

Most Active by Volume

33,974,386
  • $17.98 ▲ 0.28%
20,763,901
  • $91.29 ▲ 2.06%
19,110,793
  • $7.26 ▼ 1.22%
18,528,869
    $8.33 unch
18,014,920
  • $4.19 ▼ 1.18%
16,448,919
  • $25.83 ▼ 0.19%
14,748,190
  • $7.60 ▼ 1.43%
14,144,383
  • $112.01 ▼ 0.47%
As of 12/24/2014, 02:12 PM


Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com