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What is… Value investing

Published on 05/11/2020

We all love value. A bargain is a bargain at the end of the day. So what’s value investing? Well, it’s a strategy involving picking stocks that appear to trade at a lower value than their intrinsic value.

Value investors don’t follow the crowd or pay attention to trends, they focus on fundamental analysis to find stock they think the market is undervaluing. It’s like buying something on sale, but with a twist.

Say, for example, you’re shopping for a rug, something to make your living room feel cosier in the coming winter months, something so your child won’t hurt themselves as they start to learn to walk, something your pet can curl up on when you’re hogging the sofa. You stumble upon a stunner - it’s wool, it’s hardy, it has non-slip matting underneath, it’s the perfect colour and size. Just what you need.

You brace yourself for what will likely be a hefty price tag - looking about, the other comparable rugs are £200 or more. You turn the price tag over… but no, it’s £100! You’re getting a £200 rug for half price!

Now swap the rug analogy for stocks and you’re part way there. Say you’re reading an equity research report for a company which is trading at £100 a share, representing a market cap of £1,000. There are ten shares outstanding.

You dive deep into the numbers, and soon it becomes clear that this company can produce cash flows into the next ten or more years. You’ve crunched the numbers and get a net value of £1,200. Divide that by ten shares, and you get £120 a per share value, whilst the market recognises the company as worth only £100 per share. Bargain!

You continue to research - looking at competitors. You see that a competitor to this company you are looking at, is expected to grow earnings at the same rate, but that competitor trades at £120 per share.

Likely one of two things is true: the market has underappreciated the earning power of the company you are looking at, and at the next earnings season will re-evaluate, or the market is right and the analysts will lower their earnings estimates and price targets. Either way, you’ve found yourself a value stock.

To be a value investor, like Seth Klarman, Benjamin Graham and Warren Buffet, you have to be a detective. There are no Prime Days, or summer sales to turn to. You have to do a lot of research to find the intrinsic value of a stock from a financial analysis deep dive, covering a company’s financial performance, revenue, earnings, cash flow, debt, equity, sales, revenue growth and profit. As well as investigating the fundamental factors, look into the company’s brand, business model, target market, and competitive advantage.

Sounds like you have to be thorough, huh? Well, you have to be able to hold yourself back from being a trend follower too, and start considering that the markets aren’t as efficient at considering all information before pricing a stock - going against the efficient-market hypothesis.

Plus you have to be extra patient as you won’t get instant gratification from a value stock - these stocks are to be held for the long term; it may be years before you see an upswing. But hey, if you’re in it for the long haul, it’s all good!

From diligence, patience and a keen eye can come some great things; there’s value in value investing, and a science to being right.

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