Stock investing strategy- Value investing

In a nut shell….

In ‘Value’ investing approach, Investment decisions are made based on the basis of valuation of a share. That is, the ‘Actual value’ of the share is found out by certain calculations and the figure you get is compared with the current market trading price. If the particular share is undervalued it signals a good investing opportunity and if the share in question is overvalued, it is better to stay off from investing in that share. Whenever a share is undervalued by the market, analysts call them ‘value shares’. This is the strategy of investing is followed by masters such as warren buffet. Value investing is discussed in detail in a separate chapter.

Where did value investing come from?

Value investing was started by a man named Benjamin Graham. (1894 -1976).  He was Warren Buffet’s mentor and author of some great investing books. He is considered to be the father of Value Investing.

What’s the concept all about?

Investors that follow this strategy believe that there are two values to a stock. The current market price (which is influenced by market forces and investor sentiments) and the ‘actual’ or ‘fair price’ (called intrinsic value). Value Investors actively look out for shares of companies that they believe have been undervalued by the market – that is the current market price below the intrinsic value.

But why should a company’s share price be less or more than what it is really worth?

The answer is – The market overreacts to good and bad news, causing sharp movements in prices that do not correspond with fundamentals of the company. This  results in stock price movements that do not correspond with the company’s long-term fundamentals.  The result is an opportunity for Value Investors to profit by buying when the share price is low.

What does a Value Investor look for in a stock?

The Value Investor looks for stocks with strong fundamentals – including earnings, dividends, book value, and cash flow – that are selling at a bargain price, given their quality.  The Value Investor seeks companies that seem to be incorrectly valued (i.e. undervalued) by the market and therefore has the potential to increase in share price when the market corrects its error in valuation.

Value investors collect certain Financial and Non-financial datas about the company, and by using those data, they derive at a conclusion as to whether the share price is undervalued or not. Typically, they look at stocks with high dividend yields, high book value or low price-to-earnings multiple or a mixture of all three. It basically fundamental analysis.

Value – the defensive strategy.

Value investors focus on the inherent strengths/weaknesses of individual companies and as such market gyrations and macro-level changes do not matter to them. The ‘margin of safety’ approach ensures that the downside risk to investment is limited. However, value investing should be applied with caution. Everything that appears cheap may not be a good bargain.

Is a low priced share a value share?

Value Investing doesn’t mean just buying shares in a company where the price is declining. It’s important to distinguish the difference between a value company and a company that simply has a declining price. A sudden drop in the share price of the company does not mean that the share is selling at a bargain. The drop in price could be a result of the market responding to a fundamental problem in the company.

What are the sources to find value shares?

The best method is to do your own research. Those who do not have time may try to locate them from the indexes or from 52 week lows list. You may also validate shares of Industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one.

When can I find value shares?

Anytime. You have to keep analysing selected companies one by one. But it’s hard to find value bargains in a bullish market. Value investors go on an investing spree when the markets are down. They stay away from the market when everyone’s in and they enter the market when everyone’s washed out.

Why is this approach not used by everyone?

Only very long term investors can use the value investing approach. The reasons are –

  • The length of time that may be required to find a target
  • Once invested, an investor should probably hold for years to come. This means that an investor needs to have enough capital to not be forced to sell a holding for other reasons
  • An investor who follows and operates this method needs to have considerable patience. Waiting on the sidelines for a long time (probably many years) or holding on to an investment for a long time (sometimes a decade!) before proving your skill is not an easy trait to display
  • Value investment is a method of analysis that is very logical and rational and therefore rather seductive to potential investors. But the extreme dedication required to actually practice it makes it a method that is only really used by professionals.

Are value stocks the best way to ensure capital preservation in equities?

By their very nature as deeply discounted “on sale” securities, value stocks are safer than most other equities.  If you pick the wrong stock, you don’t lose as much as other investors because the stock is already scraping bottom.

At times, the fall in a stock’s price may be on account of impending events such as a change in industry dynamics that are not captured in its current financials. Investors who buy such a stock thinking it to be a value pick may end up with a dud.

What are the Pros and cons of value investing?

  • Pros: Less risky approach.
  • “Hot” stock tips, hype, and mass hysteria do not affect the decisions of a value investor.
  • Produces steady, consistent gains that regularly outperform the Market Index
  • Cons: On the negative side, the potential returns for value investing are smaller than those of growth investing

You may like these posts:

  1. Stock investing strategy-Fundemental investing
  2. Stock investing strategy: Technical investing
  3. Cost Averaging- A strategy you should use carefully.

1 Response to “Stock investing strategy- Value investing”

Jalen

November 4, 2011 at 1:26 am

Back in school, I’m doing so much leanrnig.

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