Value Investing Principles Will Help Secure Your Wealth
It's a truism that to be successful in the stock market, or any investing discipline, you must have a fundamental understanding of the company and its underlying financial condition. Careful, ongoing analysis of stock valuations and company expectations are necessary elements of a rewarding investment strategy.
So, it's baffling why many investors perpetually chase after the latest "foolproof" fads and "secret" strategies, switching around to and fro, chasing the previous years winners, all the while rarely achieving market-beating results. And many times destroying much of their wealth in the process.
Investors frantically scurry around searching for an investing holy grail, instead of simply easing up and taking a moment to get acquainted with a logical, time-proven approach to safe and prosperous investing, that works in both bull and bear markets, and that's been in existence since the early 1900's.
What is this old-fangled way to more safely invest in a steady, measured, wealth-building manner? What are these investing principles that can save you from rash and errant decisions that put your capital and savings at excessive risk?
It's called value investing and its based on a calculated reasoning of a businesses presumed worth or value.
Value investing often differs from the typical money-manager approach of buying a multitude of stocks in an array of industries in order to attain diversified holdings and decrease risk. More often than not, this just ensures returns that are below market indexes.
Instead, many of the greatest investors choose a relatively small basket of companies and then follow them very closely. As famed value-investor Warren Buffet proclaimed, "if you understand a business, you don't need many of them".
This does not preclude value-investors from purchasing numerous companies. But they always ensure themselves that they are going for very low valuations. This strategy came to be known as the "cigar butt" approach where you find a "cigar on the ground. It's been smoked down to the nub, but there's still a puff or two left, and they're free".
So, how does an investor using these principles approach each company they are evaluating?
A value investor buys shares in a company as though they were buying the entire company. Imagine if you will, the types of questions you might ask if you were were thinking of buying a local business...perhaps the corner rug store, a hamburger joint, or a print shop.
You would want to know if the business was on sound financial footing. Is there a huge horde of debt that must be paid off? Is the land leased or owned? What kind of income stream does the business generate? What kind of return of investment should you expect? Will your equity grow, and can it eventually be leveraged or sold?
If the answers to these questions are primarily positive, and the going price is deemed to be less than the calculated worth of the business, then you have found what can be considered a "value investment". This style of investigation and analysis is also called "bottom-up" investing. Value investors look mainly at the "intrinsic value" of the businesses they are examining, and don't get overly concerned with the shorter-term gyrations of the economy and the stock markets.
This means that patience and conviction are often required as one waits for the market to identify the unrecognized worth of the business the intrepid investor discovered beforehand.
By way of contrast, a "top-down" investor might concern themselves more with macro-economic conditions like interest rates, business cycles, and GDP growth, and how these types of factors influence his holdings.
Although looking into a mom and pop operation may be simpler than digging into a multi-national corporation, the purchasing principles remain the same. It boils down to whether a dollar can be bought for 75 cents, or 50 cents...or whatever the case may be, and will that "intrinsic value" be recognized and rewarded and some point in the future.
One might ask why value investing is not more popular and widespread?
For one, business schools seem to devote more attention to various ivory tower discussions such as the efficient market theory, which states that the results overall market can not be surpassed. All that can be known, is known, and reflected in market prices.
Another reason is that too many investors sheepishly follow the direction of their brokers. Unfortunately, this advice is often steered towards portfolio shuffling resulting in higher commissions for the broker.
Others may simply consider it too deep an intellectual pursuit and prefer to put their savings in gigantic mutual funds that regularly fall prey to annual return incentives and profit-based bonuses.
Ironically, the individual investor has the upper hand over the fund managers when it comes to finding under-priced companies. That's because many large financial firms are too big to invest in the small but still very attractive companies.
The big mutual funds cannot buy smaller companies. The mere intent to buy a meaningful amount of shares would cause the asking price to shoot up and basically make the cheap price no longer viable. Additionally, any price appreciation in such a small stock position would have a negligible impact on their overall returns.
Individual investors and smaller money-management firms do not face this dilemma. They can operate under the radar. As Warren Buffet said, "a fat wallet is the enemy of superior returns".
It is important to remember that value investing is based more on philosophy than theory. It is not simply a cookbook approach laid out in orderly steps. It is a deductive process that gets sharpened with experience. With that in mind, there are three key concepts to keep in mind:
1) The right attitude, including an aversion to speculation. It is easy to be duped by highbrowed terminology, indecipherable concepts, and convoluted calculations. Even more common is giving in to the desire to gamble and "win big".
Leading the way in this faulty pursuit is the activity of market timing. Any financial decision based solely on the premise that the market will move up or down can be considered as speculation. Instead, your investment should be based on safety of capital and a reasonable expectation of a suitable return.
2) A margin of safety. Nothing puts a damper on investment returns more so than unexpected adversity. Even if it's not expected, it should not come as a complete surprise. Be it a product recall, a regulatory investigation, or a flooding of the mine, stuff happens. A margin of safety helps to alleviate any destructive turn of events.
This is where recognizing, valuing, and purchasing assets below what they're deemed to be truly worth comes into play. Buying dollars for cents is the order of the day.
3) Intrinsic Value. Warren Buffet said that this is "a number that is impossible to pinpoint but essential to estimate". It is commonly defined as the discounted value of the cash that can be taken out of a business during its remaining life. A "discounted cash flow analysis" spreadsheet is often used. This mainly involves plugging in various assumptions (numbers) to explore different scenarios and valuations.
The point here is to formulate an estimate of a company's present and future worth. An attractive company will generate more money than is required to run the business. That excess profit will eventually be returned to shareholders in some fashion and its real value will eventually be recognized by the market.
The final take away here is - no matter how you invest, if it works, stick to it. And that's essentially what many value-based investors have been succeeding at, year after year, for a long time now.