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Guide to value investing

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.

Warren Buffett CEO of Berkshire Hathaway

 

When you invest, you obviously do so with the intention of generating a return. In order to make sustainable profits, traders adopt different approaches or strategies, and individual investment goals, risk preference and capital needs determine the specific strategy or approach each individual investor takes.

One successful strategy is value investing.

What is value investing?

The art and science of picking stocks that are trading at values less than their intrinsic value is called value investing. This strategy adopts a contrarian approach, as it goes against herd mentality, which flocks to winners. Value investing generally goes hand-in-hand with long-term investing.

As opposed to value investing, growth investing focuses on capital appreciation by chasing shares of companies poised to grow at an above-average rate, relative to the industry/sector, irrespective of where the stock is trading.

Historical value investing returns

According to Bank of America Merrill Lynch, between 1926 and 2016, value stocks returned 17 percent annually compared to the 12.6 percent return per year generated by growth stocks.

Value investing terms

Intrinsic value is the real worth of a stock, and is more often referred to as the fundamental value. Equities react to fundamental factors such as financial performance, product momentum, strength of its brand, executive team, etc. and several extraneous factors such as macroeconomics and geopolitics, which are outside the control of the company. Intrinsic value attempts to eliminate the influences of these external factors and focus merely on the fundamentals, as it solely determines the money available to shareholders.

Intrinsic value is calculated through valuation methodologies such as discounted cash flow analysis, dividend discount model, etc.

Margin of safety is the difference between the market price of a stock and its intrinsic value. A higher margin of safety is better for you as an investor, as it cushions you against potential market downturn or any poorly-made decision.

Discounted cash flow is a valuation method that calculates the present value of a stock by discounting the estimated future cash flows using an appropriate discount rate to determine the attractiveness of the investment.

Dividend discount model assumes that a stock is worth the sum of all its future dividend payments, discounted to their present value.

Advantages of value investing

  • With value investing, you are looking at a low risk-high reward scenario, as downside on an undervalued stock is limited, reducing the risks associated with it. However, when the stock rises toward its intrinsic value, the returns can be staggering. 
  • Investors need not be concerned about the day-to-day fluctuations in stock prices, as value investing focuses on fundamentals and not extraneous factors that cause these fluctuations. 
  • Value investing takes emotional decision making (which invariably leads to errors in investment decisions) out of the equation. Emotional decisions are based on gut feeling or general market conditions, while in value investing, you’ll focus on shares of companies with strong growth potential and capable of delivering outstanding returns in the long run. In the process, you’ll disregard the short-term setbacks.
  • Value investing also takes advantage of the power of compounding, as reinvestment of returns and dividends will grow your investments appreciably. 
  • Since value investment has a longer-term horizon, you get to pay a lower tax rate on your investment income. 
  • By the same token, you also pay less by way of fees and commission, given that you do not transact frequently, but employ a buy-and-hold strategy.

Disadvantages of value investing

  • The underperformance of the stock may continue for a longer period, much to the discomfort of an investor who picked it up in the pretext of a value buy. 
  • It would require time and effort to do research and analysis to zero in on a value buy.
  • Calling a bottom is a tough proposition, making it difficult for identifying the right entry point.
  • Liquidity is often a concern with value buys, given their depressed valuation.
  • It is difficult to achieve diversification with value buys, exposing an investor to significant risks.

How to get started value investing

Start with a broad list: With numerable stocks listed on the exchanges, it is quite an ordeal to zero in on the initial list. However, stock screeners such as FINVIZ could help us screen stocks using several criteria apart from scouting out undervalued stocks. This is important because not all undervalued stocks are of companies that are financially sound. Some of the criteria that can be used for the initial screening could be return on equity, or ROE, more than 15 percent, debt-to-equity ratio less than 0.5, low P/E ratio, low PEG ratio, dividend yield etc.

Shortlist: After the initial screening, proceed with a manageable list. Now is the time to examine the company more closely. Some of the criteria which can be used for further screening are:   

  • Consistent sales and earnings growth along with increasing net margins
  • Healthy free cash flow
  • Low debt levels
  • Competitive advantage
  • An understandable and viable business model
  • Availability of growth drivers
  • Fairly moderate capital expenditure requirement to maintain current operations
  • Competent management

Calculate intrinsic value: The final step is calculating the intrinsic value using any of the methods available, such as discounted cash flow method, return on equity valuation etc. Once this intrinsic value is calculated, allow a 25-35 percent safety margin at least so as to minimize the downside.

Value investing example

CVR Refining LP (NYSE: CVRR), a mid-cap stock ($3.23 billion) can be considered a value buy. This Texas-based company is engaged in the business of refining petroleum products extracted from the highly productive deposits in the central U.S.

In the recently released first quarter, the company reported earnings of 99 cents per share notably above the 7 cents estimated by analysts, on average. Revenues rose 2.4 percent year-over-year to $1.46 billion.

More importantly, the consensus expectations for fiscal year 2018 call for earnings of $1.49 per share, up an estimated 43 percent from the year-ago period.

The company’s forward P/E is a benign 13.95, expected 5-year PEG ratio is 0.05 and price/sales ratio for the trailing twelve months is 0.57 – all pointing to undervalued levels.

Given the rising oil prices, it is only going to get better for CVR Refining.

After hitting $11.15 on March 1, the stock has had upward momentum accelerating since its April 22 first-quarter earnings release. Although the run-up may deter traders, any short-term weakness can be considered a buying opportunity, considering the long-term prospects for the company.

Final thoughts

Although investment need has a huge role to play in deciding an investment strategy, the possibility of pocketing high returns at nominal risk makes value investing an excellent possibility. In order to be successful, you’ll have to conscientiously research and analyze your options to determine the right one.