Portfolio Management – We Explain How Our Value Investing Approach Works
Many investors have some idea of the principles underlying value investing. Beginning today, we are pleased to launch a new column, entitled Portfolio Management, where we will explain in detail the steps involved in our approach. We will also compare value investing with other investing styles.
Before we begin, let’s talk about the difference between investing and speculating. When I appear on business and financial news channels, such as BNN, I am often asked what I think the price of a particular stock will be a year from now. As a value investor, I can calculate the future value of a business with some degree of accuracy. Relating that business value to the future price of a stock is much more difficult.
When you see experts suggest a specific future value for a stock, market index, or commodity, it might be helpful to think of them as baseball players. The top major league players have batting averages between .300 and .400. That means that when they step up to bat there is only at 30% to 40% chance they will hit the ball. Similarly, when market experts forecast a future outcome, there is a chance that they may be proved correct, but this is also a good chance that time will prove them wrong. If you choose to follow their advice you are in our view, not investing, you are speculating. This is also known as gambling or betting.
Betting involves predicting the results of some activity—either in sports or investing–and placing a wager on the outcome. The potential gain can be great, but so is the potential for a total loss of your initial ‘investment.’
For value investors, investing in not about trying to guess future values of stocks. It’s about finding ones that are currently miss-priced or undervalued. What does it mean to say a stock is undervalued?
If you’re an avid sale shopper, you already have one of the key skills a value investor needs. As a value conscious shopper, you know that the best time to buy a 12 pack of your favourite mandarin soda is not at its regular price of, say $6. Mandarin soda might be worth $6, but you know that if you wait for the right opportunity you can get it for less. The right time to buy mandarin soda may not even be when it is on sale for $4. The deep value shopper know that if he or she waits until the soda sales cycle hits a low and they can purchase a 12 pack for just $2. Then, you buy enough soda to last you several months, or maybe even longer. You’ll be getting a $6 value for just $2.
Apply this idea to stocks and you have the essence of value investing. Before buying a stock, you want its market price to be lower that its intrinsic value. If you buy undervalued stocks in businesses that you believe will grow over time, experience has shown that you will be rewarded with incremental dividend growth and modest capital appreciation. It’s not exiting or flashy, but it does work.
In subsequent posts, we will explain the steps in the value investing process.