Value Investing Basics

In this article on value investing basics, we’ll take a look at this effective and popular approach in detail, from the key principles and terminology to the nuts-and-bolts practical calculations that you’ll need if you want to get started identifying undervalued stock.

Value investing is most simply described as an investment strategy that focuses on identifying undervalued stocks and securities in the marketplace.

The fundamental principle of this approach is to purchase assets that are priced below their true value, and thereby present an opportunity for long-term growth and capital appreciation. In essence, value investors seek to buy assets at a discount and hold them until their true worth is recognized by the broader market.

Value Investing basics: the guiding principles

Value investing principles are grounded in a few key tenets. First and foremost, value investors emphasize the importance of thorough analysis of a company’s financial position and underlying fundamentals (the real-world factors that determines how it makes its money) to determine its true, or ‘intrinsic’ value. They look for strong balance sheets, healthy cash flow, and consistent earnings growth.

While the process of evaluating potential investments involves using various metrics such as price-to-earnings ratio (P/E), price-to-book ratio (P/B), and dividend yield, all of which we’ll cover below, the underlying concept is simple: any company has a true worth in the real world, and because not all market participants are likely to be aware of this the price of its stock may less than its true value.

A simple way to think about this is to consider buying a small company . . . Let’s suppose that it owns a fleet of cars, a depot and workshop where these are stored, and lots of tools and equipment for maintaining the vehicles. Once you’ve bought the company, you sell all the cars and the buildings, and you also sell the tools and equipment. The company is essentially gone, and you’re left with a sum of cash – the proceeds from the sale of the company’s assets. If this amount is more than you were able to buy the company (or all the shares in it) for, then you’ve made a profit.

To be a value investor doesn’t mean that you go about liquidating companies, and I’ve just used the example above to illustrate the valuation aspect. In practice, you just hold the company’s stock in the expectation that the broader market will eventually wake up to its true value, and the price of the stock will rise so that you can sell it for a profit. And in the example above, we were considering things that might be easy to value, like cars; in practice a lot of the assets a company owns are less tangible and harder to value, like its brand name or trademarks.

Another essential principle in the value investing space is identifying economic moats – sustainable competitive advantages that protect a company from competitors and enable it to maintain superior profitability over the long term. Companies with economic moats are considered attractive investment prospects by value investors due to their ability to withstand market fluctuations and generate consistent returns.

Historical Success of Value Investing

Many renowned investors, such as Benjamin Graham, Warren Buffett, and Seth Klarman, have achieved remarkable returns by adhering to value investing principles. These investors’ track records demonstrate the effectiveness of the strategy in generating consistent, above-average returns over the long term.

Value investing strategies have proven effective over time, as they encourage investors to take a contrarian approach, going against market sentiment when necessary. By investing in undervalued stocks during times of market pessimism, value investors position themselves for potential significant gains when the market eventually corrects itself.

Evaluating Stocks to Identify Undervalued Companies

Once you’ve accepted the underlying philosophy at play: that the price a company’s shares trade at on the stock exchange don’t necessarily reflect its actual value in the real world at that point in time, then the next thing you’ll want to do is set about valuing companies and identifying those that are trading below their intrinsic value.

Let’s take a look at some of the key metrics and ratios that you can use for stock valuation. Each of these provide a valuable insight into a company’s financial health and help you to assess its true worth. They should always be considered collectively to form a holistic picture of the value of a company. Just because one of the ratios looks good independently doesn’t mean that you should rush out and buy stock; you need to consider the bigger picture, and there are other factors you’ll want to consider besides those that follow.

Price-to-Earnings Ratio (P/E)

The Price-to-Earnings Ratio (P/E) is a fundamental metric used to assess the relative value of a company’s stock. It is calculated by dividing the current stock price by the earnings per share (EPS) of the company.

A low P/E ratio suggests that the stock may be undervalued, as investors are paying less for each unit of earnings. However, it is crucial to compare P/E ratios within the same industry, as different sectors may have varying typical P/E levels. A low P/E ratio alone does not guarantee an undervalued gem; a thorough analysis of the company’s financials and fundamentals is necessary to make an informed decision.

Price-to-Book Ratio (P/B)

The Price-to-Book Ratio (P/B) is another vital metric in the value investor’s toolkit. It is calculated by dividing the current stock price by the company’s book value per share.

The book value represents the net asset value of the company, which is the total assets minus total liabilities. A P/B ratio below 1 indicates that the stock is trading at a price lower than its book value, suggesting it may be undervalued. However, like the P/E ratio, the P/B ratio should be interpreted in the context of the company’s industry and financial health.

Dividend Yield

Dividend Yield is a metric that measures the cash flow return on investment through dividends. It is calculated by dividing the annual dividend per share by the current stock price, and it is expressed as a percentage.

Companies that offer higher dividend yields are often attractive to value investors seeking stable income streams. A higher dividend yield may indicate that the stock is undervalued, particularly if the company’s financials and fundamentals are strong. However, it is essential to consider other factors, such as the company’s ability to sustain and grow dividends over time.

Investing in companies purely for their ability to provide dividend income is another strategy altogether. For value investors, the dividend yield is just an indicator that a company may be worth more than its stock price suggests, because the dividend distributions are evidencing the ability of the company to generate strong profits. What’s more, they can be an early indication that other market participants are soon likely to be waking up to the company’s true potential.

Earnings Growth Potential

Earnings Growth Potential refers to a company’s ability to increase its earnings over time. Value investors look for companies with a solid track record of consistent earnings growth or those expected to experience substantial growth in the future.

A company with strong earnings growth potential may be undervalued if its stock price does not adequately reflect its future growth prospects. However, you’ll need to exercise caution and conduct thorough research to differentiate between companies with sustainable growth potential and those experiencing temporary boosts in earnings.

Economic Moats: Competitive Advantage Matters

Perhaps the biggest danger that you’ll face as a value investor is when the real world changes after you’ve bought stock, rather than the stock price changing. Yes, you correctly identified that the stock was undervalued. At the point at which you completed your analysis and hit the ‘buy’ button, the stock was genuinely priced at less than its true value. But then something in the real world changed, and its competitors surged ahead with new technologies, leaving it in the dust . . .

Economic moats offer value investors a degree of protection against this.

An economic moat refers to a sustainable competitive advantage that a company possesses, which allows it to maintain superior profitability and market share over its competitors. Just like a medieval castle’s moat served as a protective barrier against invaders, an economic moat shields a company from the onslaught of competition.

Warren Buffett, one of the most successful investors in history, popularized the concept of economic moats and emphasized their significance in identifying high-quality investment opportunities.

Types of Economic Moats:

There are several types of economic moats that companies can build to fortify their competitive positions:

1. Brand Moat: A strong and recognizable brand can create a powerful economic moat. A well-established brand name not only fosters customer loyalty but also allows a company to charge premium prices for its products or services. Consumers often associate reputable brands with quality and reliability, making it challenging for new entrants to compete solely on price.
2. Cost Moat: Companies that can produce goods or offer services at a lower cost than their competitors enjoy a cost moat. Lower production costs enable these companies to set competitive prices while maintaining healthy profit margins. Achieving cost efficiencies can be a result of various factors, including proprietary technology, access to cheaper resources, economies of scale, or superior operational efficiencies.
3. Network Moat: A network moat arises when a company’s value increases as more users or participants join its network. Social media platforms, for instance, leverage network effects, wherein the more users join, the more valuable the platform becomes for all users. Such moats are challenging for competitors to overcome since users are hesitant to switch to a new platform with fewer participants.
4. Switching-Cost Moat: When customers face significant costs or inconveniences in switching from one product or service provider to another, a switching cost moat is established. This can be due to the need to retrain employees, reconfigure systems, or face compatibility issues. Companies with high switching costs tend to enjoy a more stable customer base and reduced vulnerability to competition.

Identifying Companies with Strong Moats:

Recognizing companies with strong economic moats is essential if you’re seeking sustainable long-term returns as a value investor. That’s all good, but how do you actually identify these companies? Its certainly not an exact science, but here are some approaches you can take:

1. Industry Analysis: Conduct a thorough analysis of the industry in which the company operates. Look for companies that dominate the market and have a history of consistent profitability despite changes in the business environment. Industries with high entry barriers, such as significant capital requirements or specialized knowledge, are more likely to harbour companies with economic moats.
2. Financial Performance: Examine the company’s financial performance over an extended period. Companies with superior profitability, steady revenue growth, and high return on invested capital (ROIC) are strong potential candidates for possessing economic moats. Consistent financial performance is a good indicator of a competitive advantage.
3. Competitive Advantages: Evaluate the company’s unique strengths and competitive advantages. Does it have a recognizable brand, proprietary technology, or exclusive rights to certain resources? Understanding what sets the company apart from its competitors can provide valuable insights into the presence of an economic moat.
4. Barriers to Entry: Assess the barriers to entry in the industry. Companies operating in industries with high entry barriers are more likely to maintain their market positions and enjoy the benefits of an economic moat. Factors such as patents, regulatory approvals, and access to distribution channels can act as barriers to potential competitors.

Example of an Economic Moat

So what do all the things that we’ve discussed above look like in terms of an actual company? Let’s take a look at Coca Cola as an example of a company with a strong economic moat.

Don’t think that I’ve chosen this example simply because it’s a company everyone’s heard of. Quite the opposite: the fact that it’s a company everyone’s heard of is because it’s an enormously recognisable and established international brand, which immediately ticks one of the boxes for having a competitive advantage.

The company’s flagship product, Coca-Cola, is one of the most recognizable and widely consumed beverages globally. This brand recognition and customer loyalty have allowed Coca-Cola to maintain a dominant market position in the soft drink industry for decades, and it’s fair to say that their economic moat is built primarily on its powerful brand recognition and loyal customer base.

Additionally, Coca-Cola’s extensive distribution network is another factor to consider. The company has built strong relationships with bottlers and distributors worldwide, allowing it to efficiently reach consumers in various markets, including remote and emerging regions.

Its diverse portfolio of beverage brands, including Diet Coke, Sprite, Fanta, and various non-carbonated drinks, provides it with multiple revenue streams and helps protect the company from being overly dependent on a single product. And Coca-Cola’s massive advertising and marketing budget is yet another element of its economic moat. The company invests heavily in marketing campaigns and brand promotions, not only reinforcing its brand identity, but also creating barriers for potential competitors trying to challenge its market presence.

Overall, The Coca-Cola Company’s strong brand, global distribution network, diverse product portfolio, and substantial marketing efforts collectively form a robust economic moat that has allowed the company to thrive in the highly competitive beverage industry for many years.

If you’re still in doubt, the company of one of the most successful value investors, Warren Buffet has held a considerable number of shares in Coca-Cola stock since 1988. In fact, if you’d invested $1,000 at the same time that Buffet did, that investment would now be worth around $23,326 (and that’s not including the dividend income that you’d have received throughout that period).

Economic moats are essential defensive tools for a company to achieve sustained success in the face of competition. Whether it’s through a strong brand, cost advantages, network effects, or high switching costs, economic moats create protective barriers that shield companies from rivals, and they enable them to thrive over the long run.

Contrarian Thinking: The Value Investor’s Mindset

Up to this point, I’ve mostly focused on explaining what could lead you to believe that a company’s stock has been undervalued. It’s important to keep in mind, however, that at the point you make that assessment and no matter how confident you are in it, at that particular point in time most other market participants believe that its shares are worth roughly what they’re trading at (if they didn’t, they wouldn’t be trading at that price; if everyone thought the stock was cheap they’d be buying it and bidding the price up).

In other words, as a value investor you are necessarily always going against the crowd. You’re betting the opposite way to everyone else. You’re a contrarian.

And that’s not easy position to maintain, so let’s unpack what this means a little further . . .

Going Against the Herd Mentality

Contrarian thinking is at the heart of the value investor’s mindset. While the majority of investors tend to follow the crowd and succumb to the herd mentality, value investors actively seek opportunities that deviate from popular opinion. Instead of being swayed by market sentiment, they take a counterintuitive approach, believing that the market is not always efficient in pricing assets accurately.

When the crowd is exuberant and stock prices soar to irrational levels during periods of market euphoria, value investors exercise caution. They understand that such enthusiasm can lead to overvaluation, and as a result, they may reduce their exposure to overpriced assets.

Similarly, during times of market pessimism and widespread selling, value investors see potential opportunities. They understand that market overreactions can lead to undervaluation, presenting a chance to accumulate quality assets at discounted prices.

Recognizing Market Overreactions

Contrarian thinking involves recognizing and capitalizing on market overreactions. Market participants are often driven by emotions such as fear and greed, leading to exaggerated price movements. During bear markets for example, the initial fall in the market is triggered by a realisation that stocks have become overvalued, but once intrinsic value has been reached the decline doesn’t always stop there, and the markets can continue to fall until many stocks are trading below their true value. As a value investor, this is where you can step in as a buyer.

This isn’t to say that you should become overly focused on short-term market movements and start buying at every sign of a correction. Value investors maintain a rational and objective approach, relying on fundamental analysis to guide their decision making, and ultimately the decision to buy any single stock needs to be underpinned by the valuation placed on that individual company versus its share price, not on what the S&P500 happens to be doing.

The message to take away here is that market downturns often present more opportunities in individual stocks, and these are times when you can set to work identifying solid companies with strong economic moats and sustainable growth prospects whose stock prices have been unduly punished. These undervalued gems present opportunities for you to buy at attractive prices with the expectation of long-term appreciation when sentiment returns to normal, both in the broader market and the stock in question.

Patience and Long-Term Perspective:

Contrarian thinking requires patience and a long-term perspective. Value investors understand that their investment ideas may not play out immediately, and they are willing to wait for the market to recognize the true value of the companies they’ve invested in. This patience allows them to weather short-term market fluctuations and avoid making hasty decisions based on temporary market sentiment.

In fact, day-to-day, as a value investor, you don’t usually need to be paying too much heed at all to what the stocks in your portfolio are doing.

By taking a long-term perspective, value investors can ride out market volatility and benefit from the power of compounding over time. They focus on the underlying fundamentals of the companies they invest in, confident that strong businesses will eventually reflect their true worth in the market. If the fundamentals don’t change and the stock price falls, then if anything this may present an opportunity to buy more stock at a discounted price.

Of course, I know as well as any trader that from a psychological perspective this is easier said than done. When your portfolio is losing value, which it will always do from time to time, then it’s important to be able to take a step back and remember the bigger picture and just how successful this approach has been over the last century or so.

Warren Buffett, often regarded as the epitome of a contrarian value investor, famously said, “The stock market is designed to transfer money from the active to the patient.” To my mind, this quote neatly exemplifies the essence of contrarian thinking and the importance of maintaining a patient, long-term approach to investing.