What is value investing? How looking for good companies with discounted stock prices can help you build wealth in the stock market.
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Some people believe that the stock market is financial voodoo and mumbo-jumbo, where success is a combination of luck, timing, and outsmarting other people. "Why try?" they ask. "Isn't the average investor doomed to fail?"
We believe instead that you can succeed.
The Value Investing Strategy
Value investing is a strategy of finding stocks with prices lower than the intrinsic value of the business. That's it, but that explanation packs a lot of nuance in a few words.
Contrary to other investing strategies, value investors consider several things important:
- What does the underlying business do?
- How much money can it generate over the next several years?
- What competitive advantages does it have?
- What type of return are you looking for?
- What's the current price of the business relative to your desired return on investment?
- What's the underlying business actually worth?
- How likely are you to be wrong evaluating the business?
Again, that seems like a lot of questions, but they're fundamentally answerable in a way that other investment strategies aren't. You don't have to predict what other investors are thinking in the short term, only that they'll come to realize the stock is currently underpriced for what it is.
Value Investors Love Great Businesses
Successful value investing must find great and successful businesses. These businesses bring joy to their customers. They make honest profits. They manage their debt. Year after year they earn solid revenues. These are businesses anyone would want to own because they produce real money for their owners, whether they sell farm equipment or publish newspapers or help people find what they're looking for on the Internet.
When you buy shares of these companies, you own a piece of their business. Some people believe in buying and selling shares because other people believe the price of the stock will change in the next hour or day or week. Value investors buy shares in businesses which have demonstrated that they can and will continue to succeed.
Value Investors Know the Value of a Business
A good business is not enough. Any stock worth investing in must be viable for the long haul: not just the next quarter or year, but five, ten, even twenty years. Think about Coca-Cola or IBM. These businesses continually reinvent themselves to produce new products, find new markets, and dominate their industries.
For an even stronger example, consider Berkshire Hathaway, the Warren Buffett/Charlie Munger business which started its ascendance following the Benjamin Graham value investing formula. Berkshire Hathaway has a tremendous advantage in its leadership, but it also has two fundamental competitive edges over its competition:
- Its strong presence in the insurance business (think GEICO) provides a steady stream of cash every year in the form of premiums. Though it must occasionally pay out for claims, a well-run underwriting operation manages those costs. Don't underestimate this; lots of cash coming in regularly and cash flowing out infrequently means that there's a lot of cash coming in to buy other companies.
- The strong management culture of Berkshire Hathaway, focused on the numbers, allows the managers of individual businesses to do what they do best while leveraging the parent company's position in the market as a whole. Buffett can negotiate preferred stock purchases and other financial transactions because of his reputation and history, and the market will follow him.
None of the rest of us are Ben Graham, Warren Buffett, or Charlie Munger, but we can find businesses with similar strengths and wait for them to go on sale.
A stock is more than a piece of the business. It's a share of the future revenue of the business. That's why the solidity and the earnings of the business are so important. The price a value investor pays for a stock depends on the revenue the business will produce over time. It's not investor sentiment. It's not technical analysis. It's the belief that, over time, great businesses continue to be great.
Value Investors are Patient, Not Greedy
Value investors don't try to time the market to find the lowest of the low points as the best time to buy. If a company is worth owning at its current price, it's worth owning. Neither do they try to time the market to find the highest of the high points as the best time to sell. If there are better stocks to own, it's worth selling.
Investing based on the value of a business takes patience. It takes time to find great deals. Bargains happen. Perhaps the company's coming out of a tough period. Perhaps the whole market is down. Perhaps no one has noticed this little-known company with huge prospects right now. Perhaps—and ideally—you know something about the company or the industry that will produce a huge opportunity in the next few years.
Research, buy, wait, and watch. The free market rewards the patient and the thoughtful. No one has a perfect record of future predictions, but with care, you don't have to be. Choose great companies. Do some research. If you're careful and plan well, three times out of five you can reap the reward of a value investing-based buy and hold philosophy.
Trendshare's Tools for Value Investors
Trendshare's stocks section provides several tools for investors, including a value investing stock screener. These tools are built around analysis of several important metrics, including free cash flow analysis, standard financial ratios, and even a margin of safety determined by market capitalization.
Our free analysis can be a starting point for your own research, to help you pick stocks, even if you're a value investing beginner. Our articles can help you learn the basics and build your confidence as you build experience and real wealth in the market.