Introduction to Value Investing.
This post is the first publication on Fundamental of Value Investing Series. This series has been put together from lectures and speeches of great and successful value investors. The first discusses about fundamental concepts on Value Investing, Core Principles and Basic filters to pick stocks.
Overview of Value Investing.
Value investing is attempting to buy stock or other financial assets for less than its worth also called Intrinsic Value. Intrinsic Value is one the most fundamental concepts in Value Investing and for most the most critical thing to measure, Calculating Intrinsic Value is more art than science.
Core Principles of Value Investing.
1. Intrinsic Value.
2. Margin of Safety.
Every asset class in this world has some finite worth referred as Intrinsic Value. Intrinsic value refers to real value of any asset class. One the way to think of intrinsic value is what is the value a rational cash paying buyer would pay to own this entire company. A second way of thinking about it is using a Discounted Cash Flow methodology. DCF estimates the future free cash flow of the company and discounts back to present to know what these cash flows worth today.
Margin Of Safety.
One of the most important concept in Value Investing is Margin of Safety, to mitigate future uncertainty in valuation. Margin of Satety gives advantage to investors against major downside risk. For example if something is valued around $600M – $900M, one must look opportunity to buy at around $300M of market capitalization. This is 50% margin of safety. Although this is not always possible to have large discounts available all the time. One may consider 20-25% margin of safety as a reliable safety factor against downside risk.
Growth Investing vs Value Investing.
Most people distinguish growth investing with value investing, partly it is true. Assets can trade for less than its value, and have no growth or no negative growth. Growth is one of many component of calculating of what something is worth. Growth can be bad or good depending on the way it is generated. For example some companies destroy growth by recklessly investing in their growth.
Four Important Questions in Value Investing.
– Understand one’s circle of competence.
– Value of the company or Intrinsic Value.
– Understanding Management Characteristics.
– Price of the Stock – As nothing is good at infinite price.
Circle Of Competence
The first question a value investor asks is ‘Do I understand this company or industry reliably enough to predict future performance of company or industry’. This is a very important question and one of the most critical question to ask before even try to value the company. Most of the investors nowadays think after buying any stock or equity. Investors sometimes don’t deeply understand company or industry and their pain points. If one is not well versed with the fundamental of industry and company one must first try to expand its knowledge. One should always strive to expand circle of competency and understanding boundaries and limits of one information and knowledge within that industry of company.
Estimating Value of the Company
This is also one the most critical part of value investing. Valuing a company is more art than a science. Analysts have been different in his approach to valuing any company and not two will come up with the same value most of the time. There are certain tools for valuation like Discounts Cash Flows which relies on estimating the future cash of the company and discounts back at appropriate rate to present value. But those are tools and actual valuation relies on estimating future cash flows and using appropriate risk rate for that cash flows. Some analysts use financial ratios like ROE, ROA, RIOC and Balance Sheet ratios to understand value of the company and compare these ratios to same companies within the same industry to find bargains.
The fundamental questions to ask about management are – Do they run the business well, and are they good capital allocators. Most CEOs are trained to execute businesses very well. But very few of them are good capital allocators. One more aspect about management is whether they care about minority shareholders or not. This is very important otherwise there will be leak in value of the company and minority shareholders are at very risky side of investing in the company.
The Price You are Going to Pay for the Asset.
As Charlie Munger says, Nothing is good at infinite price. Finding bargains is not an easy task. 9 out of 10 times there would a value trap. As there is too much information in markets about some industry and company, and may be market is pricing the stock appropriately, One should be cautious and ask whether I am right about the company and market is wrong.It is observed 9 out 10 time there is a bigger chance of error.
Beauty of Investing is to wait until the market makes mistake. Successful investors make few bets and they invest in bigger positions. Warren Buffet talks about this, he says imagine if you have punch card and it is only 200 punches and you have only one punch card, now imagine how thing should be cheap to get into your portfolio.
Now What’s NEXT ?
Vital to Value Investing is Variant Perception. The Second Part details more detail about Bottom-Up Picking, and Portfolio aspects of Value Investing. Subscribe to our Our Newsletter and receive up to date publications about Value Investing