Different sources define the concept of value investing differently. There are some who say that value investing is an investment philosophy, which favours buying stocks that are currently selling with “low price to book ratios,” and also have high dividend yields. Some others say that value investing is about purchasing stocks with low P/E ratios. It is also possible that you hear value investing has more to do with the balance sheet as compared to the income statement.
Investing is nothing if it is not an act of searching for the value that is at least sufficient in order to justify the amount paid. Consciously paying more for any stock than its calculated value, in the hope that you can sell it for a higher price, should be labelled speculation. It is neither immoral, nor illegal, but financially fattening.
The term value investing connotes the buying of stocks having attributes like a high dividend yield, low price-earnings ratio, or low price to book value ratio. Unfortunately, these characteristics are far from determinative as to, whether investors are indeed purchasing something for what it is worth, and therefore operating on the principle of obtaining the value of their investments. Similarly, opposite characteristics such as, a higher price-earnings ratio, a low dividend yield and a high price to book value, are in no way inconsistent with a ‘value’ purchase.
The definition of Warren Buffett is considered the best definition of value investing. Value investing is buying a stock for less than its calculated value, and where the methods used to calculate the stock value are truly independent of the stock market. The intrinsic value is calculated by using an analysis of the discounted future cash flows of the asset or of the asset values. Moreover, resulting intrinsic value estimate is totally independent of the stock market. However, a strategy that is only based on buying stocks that are being traded at a low price to book, price to earnings, and price to cash flow multiples relative the other stocks, is not a value investing. Furthermore, these strategies have proven effective in the past and they will certainly continue to work in the future.
Joel Greenblatt devised a magic formula that is also considered an effective technique and often result in portfolios that resemble constructed ones by true value investors. This formula does not calculate the value of purchased stocks. Although this formula may be effective, but it is not really a true value investing. A person cannot become a value investor unless he/she is willing to calculate the values of business. In order to be a value investor, he/she does not have to value businesses precisely, but they do have to value the businesses.
Things to note:
- Such investors should always be prepared to miss out on the short-term investment opportunities
- Such investment requires willpower. These investors sell when other people are buying, and buy when other people are selling, so it can pose psychological difficulties for some investors.
- As it is a buy and hold strategy, so it requires patience.
- Sometimes some stocks may be undervalued, not because they are out of favour with the market, but because they deserve to be.
Click on the link to find out more about Value investing course Singapore.