Value Investing 101
Buying low to sell higher sounds easy. When starting value investing can be more challenging in practice. Here is a basic overview of key moving parts and potential pitfalls. (Background)
“The intelligent investor is a realist who sells to optimists and buys from pessimists.” ― Benjamin Graham, The Intelligent Investor
The value investing philosophy that PiggyBack follows comes in many flavors. Its simple essence is trying to buy investments at valuation discounts. Its purpose is to earn higher returns and/or to lower our risk.
This post introduces value investing to PiggyBack readers who are not already familiar.
Johan Eklund, CFA
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The Value Investing Process
Here is PiggyBack's informal introduction to a typical value investing process:
Find an interesting investment or investment theme to research. Its fundamental value must be possible to appraise using some valuation model.
Gather relevant background facts and reasonable forward-looking assumptions about the investment’s fundamentals.
Set reasonable capital market assumptions (cost of capital for making similar investments).
Use these inputs in an appropriate valuation model.
3. Intrinsic value
The chosen valuation model outputs (ranges of) “intrinsic value” estimates. This is our current idea of what the investment could be worth further down the road if sold to some other buyer.
Depending on valuation approaches, this buyer could be offering future securities market prices. Or they may be a strategic acquirer, who offers to buy all the units of our investment.
As value investors, we buy investments at market price discounts to intrinsic value.
If we are conservative in our analysis these discounts offer us a "margin of safety". A margin of safety offers some "protection"* from our own valuation mistakes and bad luck.
5. Holding period
We hope prices and intrinsic values will converge (move closer to each other) within some time. If so we may receive the market return for similar risk investments plus some excess return.
The main source of the "extra" returns in value investments tends to be revaluation, from closing the valuation gap, but oftentimes better than expected profit growth adds value as well. Some value investments offer excess returns from above-market dividend yields.
From a risk perspective, a value investment can also mean lower risk for similar returns.
One reason to sell is if we find more attractive alternative investments. Another reason is if the investment becomes overvalued or too complex for us to value. After learning more we may also discover that we made a mistake by investing in the first place.
Value investors with concentrated portfolios of high-quality, predictable businesses ("compounders") are reluctant sellers.
Other value investors buy baskets of lower-quality stocks at deep statistical discounts. Such strategies can call for replacing stocks quickly if valuations and fundamentals change.
* Value Investing Caveats
Single-stock value investing comes with its own set of risks. Here are a few caveats to understand and be comfortable with before value investing:
1. Stocks are (highly) uncertain
The future for the single company, industries, the economy, and the market risk appetite are all uncertain variables. Moving further out into the future tends to increase these uncertainties. Over the life of our investments, these uncertainties multiply to give a range of likely outcomes.
So even if we buy at attractive entry conditions we expect our single investment outcomes to be very different. Especially if we only made a few investments.
To smooth out some of these swings in "luck" and to soften some of the blows from our mistakes we should diversify. Appropriate portfolio diversification means holding more investments and more types of investments (reducing correlation risks).
2. Investing skills are noisy
Diversification also allows us to get more investment experience under our belts. It increases our confidence in the scope and limits of our abilities faster.
Beyond common sense confidence, there is also statistical confidence. As active investors, we invest to beat the market. To do so over the long run we need repeatable advantages, a so-called “edge”. For smaller numbers of investments, the problem is that return and risk outcomes become very noisy. These metrics blend the signal of our edge (if any) with noise from wide swings of good or bad luck.
Increasing our number of investments with a given strategy cancels out some of this luck. And extending our measurements to at least full market cycles we get more certain of how the strategies hold up in the long run. (The real "stress test" for stock strategies is how they hold up in bear markets.) We get more certain of whether our measured return is support for investing with an edge, or not.
3. When not to try
When practicing active value investing in somewhat efficient markets it can be hard to accept that we may lack an edge for extended periods. If short on attractive risk-reward single stock ideas, we may be in a market that we are less likely to outsmart.
Now if we find the market as a whole overvalued we can still protect our capital. We may stay out in cash, or consider investing in other asset classes that we are comfortable with.
If the market has sound fundamentals and valuation, we may stay exposed via indexing. We can also invest with other active allocators whose strategies make more sense for the time being.
PiggyBack's "piggyback investing" approach falls somewhere between, making active judgment calls on allocators.