Beyond the Hype: How Value Investing Will Succeed for Investors Today

Anyone who is serious about investing in stocks, would have heard of value investing. This is a popular investing strategy.

Investors, young and old, new and experienced, have adopted value investing all over the world. Many swear by its principles. Others use it only to an extent.

Warren Buffett, the most successful investor in the world has said, 'All investing is value investing'.

But what are this investing strategy all about?

And is it useful in the current context of the Indian stock market?

Let's find out...

What is Value Investing?

Value investing is an investment approach that seeks to profit from identifying undervalued stocks.

It's all about finding out a company's intrinsic value and then buying it at a discount to that price.

When the stock rises above this price, value investors sell and make a profit.

This was pioneered by the father of value investing himself, Benjamin Graham.

• An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. - Benjamin Graham

Value investing is conceptually simple, though requires effort to implement.

The research process focuses on finding out the intrinsic value of a company and the primary tool for researching a company is called fundamental analysis. Through fundamental analysis of a company, value investors can determine its intrinsic value.

After that, value investors compare the intrinsic value per share to the share price. They buy when the stock is trading at a discount to the intrinsic value and sell when its trading at a premium to it.

The idea here is that, in the short term, market prices deviate from intrinsic values due to changing market sentiments. But in the long term, market prices return to intrinsic values.

This presents an opportunity to make profits. Value investors can buy stocks when they fall below their intrinsic values and then hold them until the stocks return to the intrinsic values.

Margin of Safety

The margin of safety is at the heart of the success of value investing. You could call it the secret sauce.

Since the calculation of intrinsic value involves making estimates, the final assessment is subjective.

Thus, there is a possibility of being overly optimistic about a company's intrinsic value. This is where the margin of safety comes in. It provides a cushion for value investors by tempering the optimism of their assessment.

Say, for example, your calculation results in an intrinsic value is Rs 100. By consideration a margin of safety of 20%, you can adjust the value to Rs 80.

This will ensure that you do not overpay for any asset if your assessment turns out to be incorrect. If the intrinsic value turns out to be Rs 90, you would be still buying the stock at Rs 80.

Holding Period

Value investing works in the long term, because it takes some time for prices return to their intrinsic value. It may not happen in the short term.

This is why value investors don't aim to predict what stock prices will do days, weeks or months from now. Instead, they look for undervalued businesses that will outperform in the long term.

They trust that the market price will eventually reflect in the intrinsic value and thus, having bought the stocks below it intrinsic value, they will make a profit when they sell.

Now this doesn't mean that value investing can't work in the short term. It absolutely can. If the market recognises the intrinsic value of a company soon after you have bought it, you can end up with considerable profits in the short term.

However, value investors don't invest with this hope. They are typically long term investors who are happy to wait a few years before selling.

In fact, they are usually keen on buying more if the stock were to fall after they buy it. The logic is that if the stock was undervalued at Rs 80 when the intrinsic value is Rs 100, then it would be even more undervalued below Rs 80.

Can You Apply Value Investing to Indian Stocks Today?

Yes, absolutely.

Value investing has a long track record of success.

Many gurus on Dalal Street swear by it having tasted success with this strategy in their careers.

A quick search on the internet will reveal many stories, from around the world, of value investments creating life-changing wealth.

At Equitymaster use value investing extensively in our stock picking and have done so for decades. We can attest to the effectiveness of this investing approach.

So, how do you go about it?

How to Find Value Stocks

The process of finding high-quality 'value stocks' involves the following 4 steps:

Step 1: Identify Your Circle of Competence

This comprises of identifying all the businesses that you are familiar with and thoroughly understand.

For value investors, it's important to invest only in businesses that they understand.

Focus solely on areas of business where you believe you have an edge over the average investor.

Likewise, staying away from what you don't understand is equally important.

Step 2: A Moat to Protect Your Castle

If we look at medieval castles, there is a deep moat around it. This moat was typically filled with water and crocodiles or other predators to keep the attackers/enemies away.

In value investing too, you should look to protect your castle.

In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage, wider is the moat. This moat would protect the business from competition.

Companies that have a wide moat are able to earn higher returns for its shareholders. They are able to do so consistently year after year, every year. This in turn is reflected in its stock price.

And if the company is able to use its competitive advantage to widen the moat over time, then it's the perfect business to be in.

Step 3: Able and Trustworthy Management

Perhaps among the various factors that need to be looked at before investing in a company, the management is the most important.

Able and trustworthy management means that management consistently demonstrates competence and works in the interest of shareholders.

There are 3 main factors in assessing management:

• The results of the company
• The treatment of the company's shareholders
• How well it allocates capital

Step 4: A Sensible Price

A sensible price for stock selection is nothing more than having a margin of safety discussed above.

It consists of assessing the company's true market value per share by various valuation methods.

These methods could be the discounted cash flow approach to find the intrinsic value or by using various valuation ratios like the widely used price to earnings (PE) or the price to book value (PB) ratios.

The dividend yield is also commonly used.

Value Stocks in India

Which Indian stocks match the value investing criteria?

This is a not an easy question to answer but getting started is easy enough. You can use Equitymaster's Stock Screener.

We suggest using Equitymaster's Value Investing Stock Screener to quickly and easily find stocks based on value investing metrics.

To find Warren Buffett-like stocks in India, use Equitymaster's Warren Buffett stock screener.

You can also read about value investing in detail in this editorial: Basics of Value Investing.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...