Guide to Value Investment Strategy

You must have come across the popular usage that you got a stock at dirt cheap price. What you are talking about is value investing, which is the investment strategy based on deep value. When you talk of value investing, the 2 most popular names that come to mind are Ben Graham and Warren Buffett.

What is exactly a value stock? It is an inexpensive stock or in other words, the stock is quoting at a price that is at a deep discount to its intrinsic value. However, the best value stocks also have other attractive characteristics that make them appealing to investors. Value of a company is normally determined by future earnings, but also by hidden assets, cash on books. intangibles etc.

What categorizes a value investing strategy?

There are no real hard and fast rules. But you can summarize some of the key aspects of value investing approach as under.

• You invest in very well-established businesses with long histories of success. It is not just any fly by night story.

• The stock must have a track record of consistent profitability. Here the focus is not just on profitability but also on consistency of profit growth over time.

• Stable revenue streams are a necessary condition. You may not see sharp spike in sales, but even any sales contraction in worst of times is limited.

• Dividend payments can be an added advantage although paying a dividend is not a sine qua non to qualify as a value stock or as a value investing approach.

• Company is not a value trap; many stocks can look like value stocks but once you enter you will find that it is not translating into higher prices. That is a segment of so called value investing that you must avoid.

Are there any advantagers in a value investing approach to stocsk?

Value investing is like bargain hunting and if you do your homework reasonably well, you can get some amazing deals at bargains. The same principle applies for a value investing strategy also. The thumb rule in value investing is to look for stocks that are selling at a rather deep discount to their intrinsic value or what they should actually be worth.

There is a good deal of research and also a good deal of price bargain hunting involved here. When do you eventually make money in value investing stocks. It happens when the market eventually realizes that there has been an obvious mismatch between the stock's current price and what it's actually worth. As soon as that is clear, share prices start moving up to reflect the higher intrinsic value. That is the time when bargain hunters or value investors actually make profits but it can be a fairly long wait so have the patience.

Value investing is also based on an important sub-principal which is called the margin of safety. This is again an interesting concept. It is the extent to which the intrinsic value exceeds the current market price. Higher the margin of safety, the better it is and lower the risk in that value investing strategy.

On a connected note, one can also look at value investing on the lines of the Moat concept that Warren Buffett has put forwards. According to Buffett, a moat is a unique advantage or edge that the target investment company has built. The moat allows the company to maintain its edge over competition even as the market gets tougher. This moat approach is another very important value investing strategy.

How to find value stocks?

Value investing requires a lot of research. The first step is in-depth understanding and research into the fundamental domain. You'll have to scan through hundreds of out-of-favour stocks to measure a company's intrinsic value and compare to current market price. The strike can be quite low and you normally look at 40-50 companies before you can find one such stock that is a worthwhile value investing play.

That sounds quite intimidating but at the end of the day it is worth the effort. By fully understanding the many ways to value a company and assess its business prospects, you can weed out inappropriate stocks more quickly to concentrate on your best candidates. Today, thanks the extensive use of technology and screeners and the added advantage of artificial intelligence, it is possible to get closer to a target stock much faster.

Come back to avoiding value traps

When we discussed value stocks earlier in this feature, we spoke about the risk of value traps. Let us understand what are these value traps and how to identify such value traps and more importantly how to avoid such value traps. There are some very common situations that can produce value traps that value investors should be wary of.

One classic value trap is the cyclical industries stocks like the ones in engineering and construction. These cyclical stocks are slow movers and often quote at low P/Es due to this cyclical uncertainty and long down cycles. Typically, the boom times, earnings can rise substantially but much of these advantages tend to disappear when industry conditions cool off. Ironically, the stock looks cheapest at the peak because the earnings have seen an artificial boost purely due to price factors as we have seen in many steel stocks in India. This can be a classic value trap.

Another popular value trap is in the case of stocks that emphasize intellectual property. They can also emerge as classic value traps. Let us take two examples. Firstly, a pharma company may be minting money from a high priced drug but may soon lose patent protection. In that case, generics are going to flood the market and take away the advantage. Also look at a retail company that is minting money but is soon going to be threatened by the digital onslaught. These can be easy value traps.

Is there a way to avoid value traps. Actually no. There is no royal route to avoiding value traps, but you can follow a simple rule here. Focus more on the future and less on the past. The company's prospects for sales and earnings growth in the coming quarters should be your guiding principle.

Is value investing the right choice for me?

Yes if you have oodles of patience. Value investing is a waiting game and you need lots of patience to win the value investing game. If your primary investing goal is to keep risk of permanent losses at brae minimum while increasing odds of positive returns, then you are probably a value investor at heart.

However, value investing is not for investors who look at the price ticker every hour or every day. It is not for investors who choose to follow the hottest tips and fads in the market. They would be misfits in value investing. They just do not have the temperament for being a long term value investor.

Value investing is for you if you are looking to adopt the principle of reduction ad absurdum, meaning willing to look at scores of stocks to eliminate and shortlist a handful of worthwhile stocks. The payback comes when the bull market ends because the margin of safety from value stocks makes it a lot easier to ride out a downturn.

How is value investing different from growth investing?

If value investing doesn't match up well with your particular investing style, you might consider growth investing. What do we understand by growth investing? Growth investing looks more at the prospects a business has to see its revenue and net income rise dramatically over time, with an emphasis on the fastest-growing companies in the market. Both companies can give good returns over the medium to longer period.

Growth investors are not very touchy about intrinsic value as value investors are. Instead, they prefer to stuck to buy high growth businesses since they believe that price will always chase growth.