4 Keys To Value Investing

posted on January 16th, 2014 by Bellmont Research Team

photoI would like to begin by introducing myself. My name’s Eric Chan and I have recently started as a summer intern at Bellmont Securities. Bellmont Securities is a strong proponent of value investing, hence in an effort to understand this investment approach, I have been looking into the aspects of value investing which I think are important and through this blog, I will share with you my insights which may be of assistance when looking to implement this strategy.

Value investing is an investment approach that has been widely adopted by many investors. Put simply, this strategy consists of selecting stocks that appear to be undervalued by some form of fundamental analysis, implying their market price is less than their intrinsic value. Intrinsic value is the true value of the company to a rational and patient business owner, and is determined by the long-term profitability of the company, not its market capitalisation. Value investors believe that in the long run, share prices are determined by changes in a business’s intrinsic value, but that many short-term fluctuations on the other hand are caused by sentiment, and therefore provide opportunities for intelligent investors with a long investment horizon. Ben Graham, the father of value investing, elegantly illustrates this with his famous quote “in the short run, the market is a voting machine, but in the long run its a weighing machine”. Value investors such as Graham adopt this strategy with confidence that the stock price, in the long-run, will converge to their evaluated intrinsic value.

A high profile supporter of this strategy is Warren Buffett who undoubtedly attests the success of this approach. Interestingly, not only does he adopt the standard quantitative methods, but he also incorporates the qualitative ones too. However, many investors who implement this strategy only derive their intrinsic value via quantitative methods.

In this post, I will bring to light some other important considerations that are required to effectively implement this strategy.

Go beyond the numbers

I have discovered that quantitative approaches usually gives a reasonably good estimation of a stock’s intrinsic value. However, through further research, I have learned that qualitative factors can be used together to provide a clearer, and more defined picture. Such factors may include management quality. The quality of a firm’s management is important because the strategic decisions are made by the managers who, as a result, play an essential role in shaping the company. Industry and competition is another factor that should be assessed when performing such qualitative analysis. It is important to look at the industry as a whole, and to delve into the growth prospects of the industry. In addition, it can be beneficial to investigate whether a firm has a competitive advantage over its competitors. Competitive advantage relates to the inherent strength of a company, that protects it from competition, and allows it to generate superior performance from its operations. Possessing a competitive advantage will generally allow a firm to out-perform its competitors in their industry.

Have a Margin of Safety

Calculating a company’s intrinsic value is immensely subjective. There are many ways to calculate this value and there is no one correct way of doing it. At the end of the day, different investors will arrive at different intrinsic values. These differences may be created by incorrect selection of assumptions or methodology. This leads to the all important question of what can be done to limit the error.

A margin of safety is popular among value investors and is commonly used to reduce the risk of incorrect calculations. In fact, Warren Buffett considers the margin of safety principle to be the foundation of investment success. It is simply the practice of buying at a large enough discount to leave room for error in your calculations. The margin of safety is essentially the difference between the market price you paid for a stock and the intrinsic value you calculated.

For instance, you may have derived an intrinsic value of $20.00 per share for company XYZ and you then adopt a margin of safety using a scenario that the intrinsic value is $17.00 per share. In theory, without the margin, prices below $20.00 are attractive but with the margin of safety, your risk is reduced because you will pay even less than what you think is fair value, in this case, only prices below $17.00 are attractive. This provides a $3.00 margin for errors in your calculations of intrinsic value. In essence, the margin of safety provides you with a safety buffer should there be a drop in value.

Don’t follow the herd

Herd instincts are somewhat embedded in all of us. They relate to our fundamental tendency as humans to be more comfortable moving in the same direction as the majority of our peers. In the context of market behavior, we generally like to go with the consensus and make investments based solely on the fact that others are making the same investments. This is due to the fear of missing out on a good investment and the belief that others possess more information than we do. This can cause large rallies or sell-offs with little or no rational evidence. These investors frequently buy at the top and sell at the bottom resulting in poor performance.

Value investors on the other hand do not follow the herd. They like to take a step back and analyze the circumstances before they act. They only care about a stock’s intrinsic value and only want to own companies that they know have good fundamentals and a good outlook, notwithstanding what everyone else is saying or doing.

Be Patient

Patience is a virtue that is highly revered by value investors. In my view, this is arguably the most important aspect to value investing. Some investors cannot seem to find the necessary patience to stick with a value approach through difficult times. They tend to rush out at market bottoms and rush in at market tops. This may result in losses, which may not have occurred if they adhered to their original value investing strategy.

It is important to remember that patience is just as essential for both buyers and holders of shares. It is necessary to wait for an appropriate margin of safety in valuation before buying, and to bear in mind not to sell too quickly when the market goes against you.

I hope you have enjoyed reading this post as much as I have enjoyed writing it. When attempting to implement this strategy, be wary not to try to get rich quick. Value investing is a long-term approach and requires patience. Of course, there will always be volatility and minor bumps along the way but it is important to stick to your strategy and to tune out the noise. In the long run, value investors are generally well compensated for their diligence and patience.

Eric Chan

Bellmont Securities

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