Modules for Traders
Trading Strategies 2
Translate the power of knowledge into action. Open Free* Demat Account
Let’s compare two similar manufacturing companies: ABC filters and Profit Enterprises, whose current net worth is 500 crore rupees each. However, ABC filters’ market capitalization or market value is 250 crore rupees. This means that the market has given ABC filters a lower valuation that is only half its net worth. Profit Enterprise’s market capitalization is 500 crore rupees. This means the market has given Profit Enterprises evaluation at par with its current net worth. So, ABC filters are trading at half the valuation of Profit Enterprises and at a discount to its actual value. Assuming that the prospects of both the companies are the same, investing in ABC filters will give a better return on investments a few years down the line. This would be a case of value investing. Warren Buffett used this concept to generate enormous wealth.
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.
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 of the 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.
- 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.
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.
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.
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
Insider Buying and Selling
For our purposes, insiders are the company’s senior managers and directors, plus any 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 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.
Now that we understand the nitty-gritty of Value investing, you’re ready to learn all about Rupee Cost Averaging in the next chapter.
A quick recap
- 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.
- Value investors use financial analysis, don't follow the herd, and are long-term investors of quality companies.