What is Value Investing?
Let me try to explain this fancy, much talked about concept “Value Investing” by using the reference of the definition of Investopedia.
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
Value Investors believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices.
Yes, value investing is indeed a strategy of identifying stocks whose current prices do not reflect their true worth. And when we say that we want to identify stocks at discounted prices, the question here is “by how much?” and that’s when we need to look at the crucial element of Margin of Safety.
Margin of Safety is the difference between intrinsic or true value of a stock and its market price. If we buy stocks with a slim Margin of Safety, it does not give us enough tolerance for error. If our judgement turns out wrong or if there is a sudden change in the planned events, we could end up losing a lot of our money. Hence, there must be significant difference in the price that we are paying or willing to pay for a stock and the price that we expect the stock to reach by the end of our investment horizon.
Investment horizon is another aspect of Value Investing that we need to be cognizant of. If you are a value investor, your investment horizon needs to be long during which any sort of short-term losses should have no bearing on your investment choices. A long-term view typically ranges between 1-3 years and beyond.
Now, it is not very difficult to understand that if you wish to be Christopher Columbus of the stock market wherein you identify stocks that the market has been unable to discover the true potential of, you need to spend a significant amount of time in doing your research in order to avoid herd mentality and make informed decisions. Value Investing is a very effort intensive strategy which requires you to not only do quantitative analysis of financials but also qualitative analysis of management practices, corporate governance, scope of growth in the business and industry, et cetera.
Pictorially, we can say that Value Investing is the triangle at the centre where the 3 circles meet. ALL THREE elements of the holy trinity of value investing are essential for any investment to qualify as good value.
I. Lack of growth opportunity limits upside due to lack of high potential earnings in the future. Even if a company has solid financials today, the lack of reinvestments in the business owing to a saturated or mature industry will mean a very slim Margin of Safety which is unadvisable.
II. Any business with a poor quality corporate governance can never generate sustained high returns because of lack of reliability. Scope for growth and plans of growing is only as good as its actual execution.
III. Sound financials is a direct reflection on the company’s current operations and reputation. Even the best practices of an industry may not be the ideal choice of action for the particular business. Every business is unique and requires a customised strategy in operations.