What Is Value Investing And Why Do Gurus Like Warren Buffet And Michael Burry Love It?
Finding promising investment opportunities in today’s market is a difficult task.
There are a lot of seasoned professionals and self-proclaimed experts who prescribe different strategies for finding the right assets to invest in. While some of them are nothing but sensationalist bluff, others can help you strike the mother lode and turn a considerable profit from your investment.
One strategy for investing that has gained significant recognition over the past several decades is value investing. The preferred strategy of gurus such as Warren Buffet and Michael Burry, it’s regarded by foolproof investing approach.
But is it really?
In this blog, we’ll cover everything you need to know about value investing to help you decide whether you want to follow in the footsteps of Buffet and Burry.
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What Is Value Investing?
Value investing is the practice of buying a stock that you believe is undervalued and selling it once it becomes over-valued.
In more formal terms, value investing requires the investor to seek out stocks that are trading for lower than their intrinsic value. The intrinsic value of a stock is determined via a thorough quantitative analysis of both the stock’s and the company’s key financial performance indicators.
Value investing is a contrarian approach to traditional investing, which revolves around investing in stocks that are growing in value.
By contrast, value investors don’t consider the present or past performance of a stock to identify it as an investment opportunity. That’s where value investing differs from other investment approaches, such as growth investing and momentum investing.
With the former strategy, investors look for stocks with high earnings per share, and thus high growth rates. The latter involves buying stocks that are showing increased upward momentum in their price trends over a brief time period.
How To Identify Value Investments
So, if value investors don’t look at a stock’s growth rate when evaluating it as an investment opportunity, how do they find stocks to invest in?
Value investors look primarily at the following five metrics to evaluate whether a stock is undervalued.
Price-To-Earnings (P/E) Ratio
The P/E ratio is the most widely used measurement in value investing.
It is calculated as the ratio of a stock’s market price divided by its earnings per share (EPS). If this value is low, it shows that an investor can buy more earnings at a lower price, and the stock is undervalued.
If the P/E ratio is high — typically higher than 15 — it means that the stock’s market price is too high to justify its low earnings, rendering the stock overvalued.
Price-To-Book (P/B) Ratio
The P/B ratio is another metric that’s commonly used in value investing.
It stands for the ration between a stock’s market value and the book value of the company. In other words, it compares the company’s market capitalization to its balance sheet bottom line — the value of the company’s assets minus the value of its liabilities.
If a stock’s P/B value is low — 1 or below — it means that the company is financially stable and it’s well-being doesn’t depend on the stock price. This renders the stock undervalued.
Price-To-Earnings Growth (PEG) Ratio
A modified version of the fundamental P/E ratio, the PEG ratio seeks to offer a more accurate valuation of a stock by factoring in its projected growth rate.
The ratio is expressed as a stock’s P/E ratio divided by its projected growth rate to analyze the correlation between the stock’s value and the company’s projected growth.
A PEG ratio of <1 suggests that the stock’s current value is not high enough to reflect its growth potential.
Price-To-Sales (P/S) Ratio
Also known as the price-to-revenue ratio, the P/S ratio is a correlation between a company’s market capitalization and its revenue.
The P/S ratio is useful when valuing the stocks of companies that are yet to turn a profit or traditionally take a long time to break even, such as young tech startups.
A low P/S ratio suggests that the company’s revenue is high compared to its stock price, which means that the stock is undervalued.
Free Cash Flow
Free cash flow of a company is calculated as the company’s revenue minus its operational and capital expenditures.
In other words, it’s the cash the company has left on its hands after paying for its fundamental expenses. Companies typically use their free cashflow to invest in research and development, pay dividends to shareholders or improve their marketing efforts.
As such, a company with a low stock price and a growing free cash flow may be considered as undervalued.
Common Value Investing Strategies
Because value investing is an investment strategy of its own, there aren’t exactly individual investment strategies under its umbrella.
Instead, when investors talk about the different value investing strategies, they mean the different methods of stock valuation.
There are two primary methods of stock valuation that value investors use: fundamental analysis and technical analysis.
Fundamental Value Analysis
As its name suggests, fundamental value analysis strategies are based primarily on fundamental financial data about a company’s performance and its intrinsic value.
Fundamental value investors typically rely on the metrics we’ve described above to determine whether the stock they are considering is undervalued. If any of those metrics indicate poor performance, it’s unlikely that the price of the undervalued stock will ever reach its true value.
And even though the fundamental analysis evaluates several important indicators, it’s not always 100% correct.
Several factors beyond those metrics can affect a stock price, including market trends and any political or economic issues that might be affecting the company’s performance.
As a result, some stocks may appear undervalued based on their fundamental metrics, but the macro conditions that equally affect them may ruin their growth potential.
As an example, consider a company that is based in a country with a poor political, social or economic climate.
While this company may display an outstanding financial performance and appear to offer great value, the risks associated with the poor investment climates may make it unsustainable in the long run.
Technical Value Analysis
Technical value investors take a more quantitative approach to discover patterns in the stock price that allow them to make informed conclusions about its value.
Contrary to the fundamental analysis, which focuses on the performance of the company behind the stock, technical analysis relies on the laws of supply and demand to determine the current value and estimate the future value of a stock.
In other words, technical analysis suggests that it is the market forces and other investors that affect the intrinsic value of a stock, not the company’s performance.
Technical analysts study the fluctuations of a stock price over a period of time to estimate what the stock might be worth in the future. This logic makes the technical analysis approach somewhat controversial among investors, as many believe that past performance of a certain asset should not be considered as an indicator of its future performance.
Thanks to its somewhat speculative nature, technical analysis has been commonly associated with trading rather than investing — let alone value investing.
Nevertheless, many value investors — including Michael Burry — incorporate technical analysis into their strategy because it could be helpful in determining whether a stock is undervalued in the short run.
Technical value investors use different methods to make their predictions. Some of the most common methods include:
- Moving averages
- Simple linear regression
- Moving average regression
- Exponential smoothing
- Weighted moving average regression
The biggest drawback of technical analysis is its speculative nature.
Relying on past performance might not be the most reliable approach to value investing if you’re looking to build a sustainable portfolio. Instead, consider implementing it alongside fundamental analysis to get a different perspective on a stock’s intrinsic value.
Benefits And Risks Of Value Investing
Just like any other investment strategy, value investing has its pros and cons that can make or break your entire strategy.
Here are some of the most prominent benefits and risks:
Value Investing Benefits
- Great profit potential: The main reason why many long-term investors turn to the value-driven approach is its great profit potential. Value investors take advantage of the snowball effect that occurs when the undervalued stock finally starts to appreciate. The more it grows, the more other investors flock to it, driving the price even higher. The return percentage on such investments can often be measured in hundreds, if not thousands.
- Low risk: Because every investment is data-driven, value investing tends to be one of least risky investment strategies.
- Accessible to small investors: Unlike many other investment techniques and assets that command large capital, value investing is accessible even to small individual investing. In other words, you don’t have to be a wealthy institutional investor to invest in undervalued stocks— as long as you have the necessary background knowledge.
Value Investing Risks
- Poor diversification: Many value investors make the mistake of only investing in undervalued stocks because of the profits this approach promises. This leads them to develop a kind of a tunnel vision, where they start focusing on a few specific industries or companies. This can lead to poor portfolio diversification and completely negate the low-risk benefit of undervalued assets.
- Good opportunities are hard to find: The data- and research-driven aspect of the value approach that lowers your risk has a flipside. — finding good opportunities takes a lot of time and effort. To conclusively determine whether a stock is truly undervalued, you’ll need to gather and analyze a great amount of information, which takes patience, commitment and time.
- Slow turnaround: Value investing is all about the waiting game — even if you find a great undervalued investment opportunity, it could take months or years until its value grows to the point where it can bring you profit. This could pose a risk to your entire portfolio if it’s not very liquid, as you might end up stuck in your position while losing money.
Wrapping Up On Value Investing
The value investing strategy — investing in carefully chosen stocks that are trading below their intrinsic value — is appealing to big and small investors alike.
On one hand, it can bring you great profits while maintaining a low risk. On the other, it requires significant research and commitment to your positions, even if you’re yet to make any profit.
Nevertheless, it could be a great addition to your investing approach if you have the patience to watch your profits grow over years and even decades. After all, this approach has made billions for the likes of Warren Buffet — so you might consider giving it a shot.
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