Portfolio Management – The Concepts Behind Value Investing
The concept of value investing is not that complex: Identify securities that are priced below their true value. However, to be a successful practitioner of value investing is far from simple. Successful practitioners require knowledge of business and accounting principles, diligence and an analytical inquisitiveness, and, patience.
All value investors adhere to several basic concepts:
Portfolio Management – Value Investing Concept #1: A Company’s worth or value can be estimated
The value of an enterprise is not static. There are a myriad of exogenous factors affecting the value of a company at any point in time: the level of interest rates, the state of the economy domestically and internationally, the regulatory framework, the structure of the industry, tariffs, taxes, etc. Then there are the endogenous factors that impact value: operating margins that can be effected by the costs of inputs such as materials and labour, operating efficiencies, taxes specific to the organization, financial leverage, the re-investment of earnings and the profitability available for shareholders. Finally, the value of a company can be influenced by the requirements of the individual potential purchaser and their objectives.
Market participants are constantly monitoring these factors causing prices to change continuously. Warren Buffet, perhaps the most famous value investor, has often stated the “in the short term, the market is a voting machine; in the long term it is a weighing machine”. What he means is that a number of factors or sentiment can influence prices, but in the long run good strong companies will survive and prosper and their value will grow.
Most people would agree that whether you buy a new Samsung 50″ Smart TV when it’s on sale or when it’s at full price, you’re getting the same Samsung 50″ Smart TV with the same screen size and the same picture quality. You can choose to buy I today at full price or you can hope that it goes on sale and that you get a bargain. Stocks function in much the same way: prices are constantly changing and all levels various market participants are busy buying and selling. Stocks, like TVs, go through periods of higher and lower demand. These fluctuations change prices, and at some point, they may be priced at a level that you are comfortable paying.
However, unlike TVs, stocks will not be on sale at predictable times of year such as Boxing Day. If you are willing to do a little detective work to find stocks that are on sale, you can buy them at bargain prices that other investors have yet to appreciate.
Portfolio Management – Value Investing Concept #2: Always Incorporate a Margin of Safety
Another aspect to the discipline in value investing is estimating what your upside potential gain is relative to the downside or potential loss. The analysis requires that various scenarios be examined in the case that things do not work out as planned.
Buying stocks at bargain prices will likely give you a better chance to make a profit when you sell them. The corollary is that it should also make you less likely to lose s great deal of money if the stock doesn’t perform as you hoped. This principle, called the margin of safety, is one of the keys to successful value investing. However, value investors do not pretend to be smart enough to tell when a particular security is at its lowest point or highest. That is why value investors attempt to purchase securities when they estimate the upside price appreciation is considerably larger that the potential price decline.
If you determine a stock has an intrinsic value of $100 and you buy it for $66, you can potentially make a profit of $34 simply by waiting for the stock’s price to rise to the $100 it’s really worth. Also, a well-managed company should grow over time and become more valuable, giving you a chance to make even more money. If the stock’s price were to rise to $110, you would 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 he perceived they were priced at two-thirds or less of their intrinsic value. This was the margin of safety that Graham felt was necessary to earn the best returns, while minimizing downside risk.
Portfolio Management – Value Investing Concept #3: Diversify because The Market can be Wrong Longer than you can be Solvent
The hunt for under-priced securities often leads value investors to look at companies that are not currently in favour. This is often called “contrarian” investing. As in Concept #2, a value investor may but a stock only to see it either not move, or decline in value. While you are waiting for the rest of the market participants to recognize the value that you perceive to exist, a long time period can elapse. Of course, when a security declines in price, particularly if it declines below the level that you determined to be the downside limit, you must constantly be monitoring and testing your assumptions.
For this reason, value investors diversify their investments in order that some of their holdings may be performing well while others are currently languishing. The degree to which you diversify is highly dependent on your own particular risk tolerance. While some investors may feel comfortable holding only a handful of stocks, others prefer to have twenty or more stocks in their portfolios. You want to hold enough securities representing business cycles that are less correlated with one another that no one security will cause catastrophic deterioration in your portfolio while not holding too many securities that together will just mimic the overall market environment.
Portfolio Management – Value Investing Concept #4: Investing Requires Diligence and Patience
Value investing is a long-term strategy; it does not provide instant gratification. Value investors spend their time studying the fundamentals of the companies in which they invest and little time concerning themselves with the macro-economic environment. It is your valuation discipline that leads you to find companies that meet your criteria. Do not expect to buy a stock for $17 on Tuesday and sell it for $30 on Thursday, although this may occasionally happen. In fact, you may have to wait years before your stock investments pay off. Value investors typically invest with a three to five year time horizon in mind: long enough to persevere though a business cycle.
Value investing also requires good judgement: you cannot simply use a value-investing formula to pick stocks that fit desired criteria. Some valuation techniques and criteria are more suited to some, but not all, companies. You must have the patience and diligence to stick with your investment philosophy even as your picks go through the inevitable market downturns. Resist the temptation to switch styles mid-stream, as this is where many investors get whipsawed.