“Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized” – Seth Klarman, legendary investor and Chief Executive of Baupost Group
As said by Klarman, Value investing at its core, is simple but not easy…
There are many moving parts when it comes to value investing, with the vast amount of information available, the key is about filtering down to the essentials and focusing on core principles.
In this post, I will walk you through the framework I use to pick high-quality value stocks and explain the essential concepts in value investing.
So if you are a new investor and you want to know how to pick value stocks. This is for you…
Even if you have been investing for some time, read on and you might just find practical insights that might improve your investing returns.
Here are 5 essentials of value investing that you need to know before you get started.
Value Investing Essential #1: Invest In Good Businesses
In a 1996 Berkshire Hathaway meeting Warren Buffett said “If you find three wonderful businesses in your life, you’ll get very rich”.
Well, that’s easier said than done… how do you actually do it? As a new investor, you may hear this and wonder what actually makes a company an excellent business and how to spot one.
Essentially, value investors want to own companies that are high-quality and leaders of its industry while generating sustainable excess-profits. A company with these characteristics typically have an edge over its competition, in business, it is also known as competitive advantage.
Now just imagine, if you had all the money in the world, would you be able to build a company that could overtake Coca-Cola as the undisputed leader in the soft drink industry?
How about Johnson & Johnson with its vast amount of trademarks, patents and brand name products?
Or even Alphabet Inc.’s Google with its legions of tech engineers and AIs?
If your answer is no, that’s because these companies have a durable competitive advantage – they do things their competitors can’t reproduce.
Competitive advantages are important for value investors – when a market or product yields high profits, naturally, it will attract competitors. Competition will eventually eat up market share as it saturates the supply of products or services in the market.
In other words, competition makes it difficult for most firms to generate long-term excess profits since any advantage is always at risk of imitation.
Sometimes these advantages are easy to spot like Coca-Cola and Google because they are part of our daily lives. However, other advantages such as patents, regulations & licenses require a trained eye to identify them.
The key is to view these stocks like a business owner. This means that value investors should understand how the business makes money, its competitors, the industry it operates in etc.
Business-like investing approach will help you to make intelligent investment decisions. As value investors, we want to invest in companies that are clear winners. Companies that continue to grow over the long run, so that we can profit from capital appreciation and dividend income.
Value Investing Essential #2: Invest In Good Management
Wonderful business with poor management is a bad investment, we want to look for managers who can maintain or grow the company’s competitive position and advantage in the industry. It is important to analyse a company’s management team to understand their future plans and vision for the company. We want to know if they have a history of keep promises made to shareholders.
When investing for the long run, the quality of management – including integrity – is more important than current profitability, because profitability can’t be sustained if management quality is poor.
First and foremost, track record matters a lot. You want to look for senior managers who have a proven record in their respective companies or industry. This coincides with Warren Buffett’s principle of staying in your circle of competence.
Take Microsoft’s Satya Nadella for example, prior to becoming Microsoft’s CEO in 2014, he worked in several of its divisions such as R&D, Cloud, and Business Solutions for 22 years and held many senior-level positions within the company.
In the years since becoming CEO, Nadella has exceeded expectations, as reflected on Microsoft’s stock has tripled, with a 27% annual growth rate.
In December 2018, Comparably name him the best CEO of a large company in the United States, citing Nadella’s employee reviews.
This simply proves that if a CEO has a track record of doing well in related companies or within the industry, he/she has the necessary competence to grow the company.
Another factor to note is the commitment of senior managers, find out whether the senior managers own company shares and whether they keep shares they are awarded as part of their compensation.
If the senior managers of a company sell their shares soon after the shares are awarded or after they exercise their stock options, you need to investigate the company carefully.
The success of any business depends on the effectiveness of its managers. Good managers need to make the right decisions and ensure the business takes any opportunities open to it. At the same time, good managers protect the business by anticipating any threats against competitors or economic downturns.
Value Investing Essential #3: Invest At Good Prices
Once we have identified the ideal stock with strong fundamentals and good management, we must buy its shares at a good price.
To prove how essential this is, let’s consider 2 hypothetical investors, John and David. John is a discipline value investor who only invests at good prices, no matter how great the growth story is.
On the other hand, David is a growth story junkie, he buys whatever is hot and promising, regardless of valuation. So who do you think will outperform in the long run?
Eyquem Investment Management conducted a study on the performances of 2 sets of portfolios; Value (low P/E & P/B stocks) and Glamour (high P/E & P/B stocks). Let’s assume John (the value investor) invests in the Value portfolio while David (the growth investor) invests in Glamour.
In a 33 year period (1980-2013), the historical performance of the 2 portfolios shows that the Value portfolio generated an average yearly return of 14.1% while the Glamour portfolio averaged 8.3% annually.
The difference meant that the Value portfolio outperformed Glamour portfolio by 5.8% annually.
So how much does 5.8% of excess profits translates in dollar terms? Well, assuming John and David invested $10k into their portfolios back in 1980, their ending balance looks like this:
What a difference!
The Value portfolio generated about $777k while Glamour generated only $138k over the 33 years – that’s a difference of $638k!
In other words, the Value portfolio generated 5 times more profits than Glamour. This proves that when investing in stocks, PRICE DO MATTER. The price you pay can make a difference between a potential 10 bagger or a 2 bagger.
Now that we know the importance of valuation, the question is how do we determine value? There are 2 ways to determine value; you can derive value from a company’s assets or potential earnings. Let me illustrate this in layman for you…
Meet Tom, he bought a $1 million apartment and have paid $600k thus far, which means he still owes the bank $400k (let’s assume interest payments are included in this calculations for simplicity sake). After years of savings, he has accumulated $200k of cash at bank for emergency purpose and owns an investment portfolio worth $400k.
Now, his estimated net worth will be the sum these;
Cash at bank + investment portfolio + total amount paid for condo = 200k + 400k + 600k = $1.2 million.
These assets represent the liquid net worth that he can liquidate or collateralize for future use. In the context of valuing a business, we can consider balance sheet items such as fixed assets and current assets, subtracting it off all liabilities. This difference is known as Net Asset Value.
The second method is value derive from potential earnings, using Tom again to illustrate, assume Tom earns $200k yearly and expects zero to little salary increments over the next 6 years. If things remain the same, Tom expects to earn $1.2 million in total earned income over the next 6 years. These cash flows are yet to be earned but if Tom decides for a career switch, he should certainly consider his future earnings.
In this context, to value a company from its potential earnings. The ability of a business to grow its earnings year after year determines the valuation of the company. A company with high growth is very likely to generate more profits in the future, hence investors are willing to pay more for such companies.
To evaluate the value of the company, you can utilize financial ratios such as Price to Earnings, Price to Book Value and Discounted Cash flow model to help you identify a good price to invest in a company.
Value Investing Essential #4: Invest With Margin of Safety
Let’s pretend that you’re a construction engineer who is tasked to build a bridge. You’ve been told by the project manager that heavy-duty trucks passing the bridge may weight as heavy as 40 tonnes. Would you build a bridge that can hold up 40 tonnes or 60 tonnes?
Of course, if you’re a smart engineer, you would have built a bridge that can hold up to 60 tons.
For the simple reason that if your assumptions are wrong, you would have enough buffer to avoid fatal mistakes.
The same principle goes for investing. When we make assumptions or calculations in valuing a stock, we should always assume possible errors.
Which is why we should always seek a margin of safety.
The margin of Safety is the difference between the intrinsic value of the stock and its current share price. The margin of safety principle was popularized by Benjamin Graham and Warren Buffett. The margin of safety provides a cushion against errors in analysis or valuation.
For example, if company XYZ has an intrinsic value of $10, while it’s stock price is currently at $5, the margin of safety is 50%. Buying XYZ at $5 would certainly reduce the downside risk of the investment as it is already at a huge discount to its intrinsic worth. Hence, the wider the margin of safety, the more buffer you have in an investment.
In the same statement, Buffett also said “You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.”
Seth Klarman, well-known value investor and author of the book “Margin of safety” wrote:
“Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”
In this short paragraph, Klarman was emphasizing the importance of having a wide margin of safety given that investors are capable of making mistakes and are prone to errors when evaluating a business or calculating its intrinsic value.
Value Investing Essential #5: Circle Of Competence
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” – Warren Buffett
In other words, “circle of competence” refers to knowledge, work experience or an area of focus which matches an investor’s skills sets and expertise. Simply, this is a way for investors to differentiate what they really know and what they think they know…
A circle of competence helps you to identify and understand stocks in your professional domain. For example, an investor who works in the healthcare industry (eg doctors, nurses, specialist) would be better off investing in pharmaceutical stocks or healthcare stocks, simply because they already have an underlying understanding of this field.
An engineer is more familiar with engineering companies than an equity analyst who covers multiple industries. Or perhaps a retail manager would understand consumer goods stocks better than the investing crowd.
As a broker, I deal with investors from varying backgrounds. Some are doctors, engineers, real estate agents etc. However, most of these investors never seem to invest in their own circle of competence.
For example, I’ve seen doctors investing in oil & gas stocks or mining stocks, areas where they have no knowledge. Many of them seem to pick investment ideas from the top volume list and buy whatever that’s hot and popular. It’s important to be able to define the boundaries of what we know so that we do not stray too far into unknown territory.
If you can understand the stock or industry quickly and easily, then it should be processed immediately and made sense of. Conversely, if the stock or industry is either too complex or tough to comprehend, then you should filter it out and ignore it completely.
You don’t need to look at every sector to discover hidden gems in the stock market. You only need to concentrate on the sector which you can understand easily.
It’s a win-win-win situation. Save time! Less risk! More returns!