Value investing is perhaps one of the most widely known
methods to pick stocks. When a person who is new to investing thinks about
trading stocks, value investing undoubtedly comes to mind. The strategy was
formalized by Benjamin Graham in the 1930s in his books Security
Analysis and The Intelligent Investor. Some of the better known
value investors include Warren Buffet and Benjamin Graham.
The main premise of value investing is the rejection of the
Efficient Market Hypothesis. 8 After all, if the market always
assigns the correct value to stocks, it is impossible to ever buy stocks that
are undervalued. Rather, value investors follow the mindset of Benjamin Graham
who believes that the market is irrational and will not always price a
company's stock correctly, but will often undervalue it or overvalue it. In
fact, one of his most popular followers, Warren Buffet said, «In the short
run the market is a popularity contest. In the long run, it is a weighing
machine.»9
Based on this philosophy, value investors look for good,
solid companies, that for one reason or another are selling really cheap
compared to their intrinsic value and not historical prices. Value investing is
a strategy of buying stocks whose intrinsic value is higher than the price that
the market has assigned to it. It's important to note that this does not refer
to the actual stock price. Some may confuse value investing with just buying
stocks because they are cheap ($5 a share rather than $300). This is not the
case. Value investing is based on the understanding of the fact that when you
purchase a stock, you are purchasing a part of a living, breathing and
operating company. The value investor sees stock ownership as a means to owning
a part of a company, rather than just gambling on a stock hoping it will go up.
The performance of the stock, and the price of the stock in the market will
undoubtedly eventually be based on the performance of the company. One of
Buffet's most known phrases is that «time helps great companies and
destroys mediocre ones.»10 Therefore, it is necessary for the
value investor to assess how good of a company it is that he or she is buying.
When
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Investopedia.com
9 Robert Hagstrom, The Warren Buffet Way( 103)
10 Robert Hagstrom, The Warren Buffet Way( 147)
buying a computer, the customer has to look at its processor,
how much memory it has, how big it's hard drives are and many other factors in
order to assess its future performance. In comparison, the value investor must
look at numerous key measurements of the company's performance in the past in
order to assess whether this is a good company to own a part of. These
measurements will often be found on the Balance Sheet, Income Statement and
Statement of Cash Flows which every publicly traded company must provide
quarterly, as well as many other places such as the Shareholder's Report,
company website, or the company's Investor Relations department as well as the
internet. This paper goes into detail on how to locate them in a further
section. These values include everything from how the management runs the
company, to how much debt the company has, to how much money it earns annually,
and many other different factors. A value investor's job is to look at all
these values, known as fundamental measurements, and make a decision as to how
much the company is worth, or its intrinsic value. It's worth noting, however,
that different investors will judge intrinsic value differently. If two
investors were given the same information, they may come up with two completely
different estimates of intrinsic value. Once the intrinsic value is known, the
investor will compare it to the current market price, and if the stock is
trading lower than what the investor believes its worth, he or she will
purchase shares. Therefore, he or she is usually not interested in the day to
day price fluctuations of the stock because he or she knows that he or she has
picked a solid company that is posed to perform well.
For example, Tony is thinking about which companies are good
to add to his portfolio. He decides to look at SBUX, a Starbucks stock that has
been trading for around $40 a share until recently when it fell to $15. He is
wondering if SBUX's price fell because the market has undervalued it, or
because there is something wrong with the company. He spends a few days
researching the company, looking at P/E ratios, statements of Cash Flows, and
many other different quantitative factors. He also looks at the recent news
about the company, recent changes in management and other qualitative
factors.
He then makes a decision that to him, Starbucks is worth $45
a share, because it's a good solid company and has a bright future and bright
expansion plans. He sees now, that he can get a bargain because the price fell
to $15 a share, so he buys. He doesn't really care to look at day to day market
fluctuations and he is not biting his or her nails off because he is afraid he
will lose his or her investment. He knows he has bought a solid company. In two
weeks, he checks to see that the stock has risen back up to $40 dollars.
He then decides to take a look at some of the other stocks in
his portfolio and sees that a company with a stock symbol of WINS, which he
bought for $7 a share has fallen to $4 a share. He is wondering if he should
buy more. He re-evaluates his or her stocks, taking his time to do research,
only to find out that the management changed in the company for the worse. He
decides to sell his stock so that he won't lose any more money. The company
eventually bankrupts. In this case, the price fell, but it was the market's
reaction to a change in management for the worse. The market has evaluated the
price of the stock correctly.
