What is Value Investing and How Does it Work?
If recent news about GameStop and AMC have you swearing off the stock market as having too much volatility to trust with your hard-earned money, it would be an understandable feeling to have. However, just because a few stocks went through an astronomical boom and bust cycle doesn’t mean that all stocks perform that way. In fact, investing in the stock market is still one of the most surefire ways for you to grow your wealth—assuming that you have a solid understanding of what you’re investing in and how you expect it to perform.
While many investors take a passive approach to investing, allowing the stocks they purchase to slowly grow in value over time, value investing (sometimes called “intelligent investing”) is a more active tact to take, credited by investors such as Warren Buffet as being one of the biggest reasons for his massive wealth and cash flow.
Just because value investing is Warren Buffet’s go-to investment strategy doesn’t mean you need to be a financial genius to learn to value invest. Read on to get an overview of value investing and learn how to get started making your own value investments in just a few, short steps.
What is value investing?
While Warren Buffet, Charlie Munger, and Berkshire Hathaway are likely to ring more bells to you than the name Benjamin Graham, Graham is actually credited as the Father of Value Investing thanks to his book, The Intelligent Investor, which outlines a value investment approach.
In The Intelligent Investor, Ben Graham puts forth a simple premise: that an intelligent investor does thorough research prior to making an investment in a company, and that that research hinges on what you believe a company’s intrinsic value is.
Before even purchasing a stock, value investors look for investment opportunities based on whether they believe the stock price is undervalued. By only purchasing undervalued stocks, it’s possible to turn a profit, since the share price you buy in at is lower than what you perceive the true value of the asset will one day be.
Whether for the short term or long term, analyzing the market value is the main key to determining whether you’ll want to purchase any given stock. The old phrase “buy low, sell high” rings true in connection with value investing, since if you buy a company at a low price with the belief that it will increase over time, you’ll make money if your valuation is correct and you sell at the higher price.
How to get started
Value investing is simple to do as long as you have an analytical mind and a willingness to dig into and research a company’s past performance and future plans. Here are the three most important considerations to make as you get started value investing:
The first, and most important, aspect of value investing is to do your research. If you get sloppy with your research you may miss an important detail that clues you into whether or not it makes sense to invest in a company or not based on the valuation you calculate.
For example, let’s say that you look at the stock of a company that helps people buy discounted tickets in the live entertainment industry. Obviously, due to COVID-19, that company’s value is likely to be relatively low right now, since most people aren’t going to large, public gatherings like concerts or theatre. However, you might do a bit of research and realize that based on the previous year’s financial statements, when they’ve been able to operate their stock has stayed at roughly $40 or $50 a share.
If the current price of the stock is only $10, this may seem like a no-brainer to you. However, it’s important to look at other documents such as balance sheets and even staff rosters to make sure that the company is in otherwise good health. For example, if the CEO responsible for the previous four years of great performance left because of the pandemic, it might be a bit more of a gamble to buy in—even at $10. That being said, if you learn that the company has hunkered down for the duration of the pandemic and has a solid amount of cash reserves on hand to tap and hit the ground running when it’s safe to do so, you may determine that there’s a high likelihood that company will perform well when it’s able to.
Beyond targeting companies with a consistently positive performance for shareholders, it’s also a good idea to weigh other factors about them such as their financial structure, plans for the future, and what members of the team have stayed consistent over the past several years. Short-term buzz may cause a small spike in a company’s stock (see: GameStop and AMC over the past two weeks); however, that bump in popularity is likely to be short-lived if the company doesn’t have the business acumen to build upon the increase in value.
It’s a good idea to identify whether or not the stock price offers a good margin of safety for you at its current value. Knowing that you expect the price to go up $20 gives you a wide enough margin of error that even if your calculations are off by $10, you can still make a solid return on your investment.
Diversify your portfolio
Just like any other form of investment, it’s crucial to diversify your portfolio as a way to protect yourself from market volatility. Investing in a mix of value stocks as well as growth stocks and mutual funds can give you a competitive advantage by keeping you from relying too much on one single stock’s performance to impact your net worth.
Beyond having your portfolio distributed across multiple kinds of securities, it’s just as important to diversify which value stocks you’re investing in. Spreading your investments across a few different companies that you expect to offer good returns, in the long run, can be critical to mitigating your losses from volatility.
Don’t get greedy
Part of value investing or intelligent investing is picking consistent returns over the next hot stock. By seeking reliable returns rather than the potential for a massive spike or dip, you’re going to have a much better track record over the long run.
Taking a long view also ensures that your analysis is focused on a company’s long term sustainability. Businesses like Apple and Amazon are sound investments because they offer their shareholders dividends time and time again. Picking a company with a steady business plan rather than the next hot thing can be just as important as picking a company that is undervalued if you want to make money as a value investor.
Depending on which brokerage you use, there may be fees associated with the transactions you make buying and selling stocks. These fee structures vary from brokerage to brokerage, so be sure to read up on your brokerage before you make any value investments.
It’s also worth remembering that you should only invest money that you can afford to. Investing carries with it inherent risk, and no investment you make is guaranteed to offer you a solid return. Make sure that you’ve budgeted for other aspects of your monthly expenses prior to putting any money in the market.
Can offer solid returns
A big benefit of value investing is that it can offer substantial returns, particularly if investing in a stock that is wildly undervalued.
From hedge funds to personal investors, value investing strategies have been used for over 60 years to help investors make money in the stock market.
Requires active work
Unlike a passive investment strategy, you’ll need to put in time and energy if you want to see results as a value investor.
Unlike growth investing, which focuses more on selecting stocks based on their growth rate, a lot of research must be conducted about a company before you decide to value invest. As such, this territory definitely comes with a learning curve.
Bottom line While value investing isn’t for everyone, it’s a sound approach to investing that can ultimately offer you great returns. Popularized by investors like Warren Buffett, Benjamin Graham, and even hedge fund managers like David Abrams, value investing is a strategy that works.
By buying stocks at a value lower than their intrinsic value, you can find consistent returns as the general marketplace catches up to perceiving a company at its true value. That being said, there is a considerable amount of work that needs to be conducted prior to making a value investment. If you’re not someone who’s confident in your capabilities and financial research, it may make sense to find a different approach to making money in the stock market.
Ultimately, it’s important to find an investment strategy that works for you. If you like performing research and taking an active role in your portfolio, value investing is a great option to consider.