Value Investing is a strategy of investing where investors pick stocks based on fundamental and technical analysis and invest in those that are trading lower than the intrinsic or book value.
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It was developed in 1920 by two professors of Columbia Business School- Benjamin Graham and David Dodd MS. Value Investing got famous with the renowned book- ‘The Intelligent Investor’ by Benjamin Graham, who is also known as the father of Value Investing. The book is considered a Bible for Value Investing and has made Value Investing a well-known strategy around the world.
Warren Buffet is the most famous value investor you would have heard about, who was also a student of Benjamin Graham. After him, there came many value investors like Charlie Munger, Christopher Browne, Seth Klarman, Walter Schloss, Peter Lynch, John Neff, Joel Greenblatt. Every investor has his strategy or theory, but some rules remain the same for all.
Here are our 12 rules of value investing:
- Objective – An investor should always write down his goals and always keep in mind his purpose while investing.
- Historical Performance – One should take the past performance of both- the stock and the market into consideration. Still, the decision should not be made solely on that performance as the circumstances can change over a period.
- Earnings Per Share (EPS) – Graham considered those stock which had an EPS double the 10-year government bond rate.
- Price to Earnings Ratio (PE Ratio) – The ratio helps an investor to know if the stock price has incorporated all the earnings or not. Usually, a PE ratio of 40% of the highest PE ratio of the last five years is considered ideal.
- Dividend Yield – The dividend yield should be 2/3rd times of the 10-year government bond.
- Free Cash Flow – FCF is the amount of cash left with the company after deducting all the expenditure from the revenue generated. It also tells us about the company’s future growth as more the money more the company can invest in its future activities.
- Margin of Safety – There is always room for error while investing, so value investors keep a margin of safety so that if estimates go wrong they don’t incur huge losses. Benjamin Graham used to keep a margin of safety of atleast 2/3rd of the intrinsic or book value and invested only if the stock’s current value was less than 1/3rd of the book value.
- Peer Comparison – Value investors should compare the stock with the industry peers after looking at the financials. This can be done by relative ratio analysis and can also be compared to industry benchmarks.
- Diversification – The old saying goes along, “Don’t put all your eggs in one basket.” Value investors should not invest in one stock and try to diversify their stock portfolio. They should not put all their money at once and should do it over some time.
- Knowledge – As Warren Buffetrecommends investing in those stocks whose business you are familiar with or know it by depth. But one should also keep in mind that they don’t indulge in crimes like insider trading.
- Long-term Period– Value investors should always focus on investing for a longer period, but it’s up to the investor’s discretion what long-term is to him. Warren Buffet says that when he invests in a stock, he forgets that it will be trading for the next five years.
- Blue-chip companies – The blue-chip companies are the ones that are found to be undervalued, and thus it is advised to invest in such companies. Warren Buffet usually invests in Blue-chip companies.
One should keep in mind that these rules don’t promise profits; these are just to be keptin mind while investing in stocks. A person can modify these rules as per their analysis, thinking, and need. Every investor should invest according to the amount of risk they can bear, their time horizon,the expected profit, and their investment goals.
A value investor should always invest in the business and not stock because, as Warren Buffet says, “If the business does well, the stock eventually follows.” The investor should always look at the phase of the cycle of the business, market, and stock while investing. He should always look at numbers and not let his emotions affect his buying decision, as the decision would be based on personal bias and not on analysis.
But it’s still a game of patience as markets move according to demand and supply, due to which people follow the trend and start selling when the market is bearish and would buy when the market is bullish. Here is the opportunity for the value investor to grab and make a smart investment. When the market is bearish, the stock usually gets undervalued, and the value investor must find such stocks and invest. Though there is no secret mantra for making a profit, you can use value investing strategies, which can help you reduce the risk of losses.