Value Investing made sense to us...
When my wife and I started our investing journey, like a lot of others, we had heard a lot of bad things about investing in shares. However, to expand our investment portfolio for long-term wealth we did recognise that we needed to invest in a business. Not wanting to start and run our own business we sought to find out what other options there were. Thankfully, our Financial Adviser recommended we explore Value Investing. Now we happily invest in great businesses! Read on to find out why...
What is Value Investing?
If you search for “Value Investing” on the Internet you will see a lot of similar, but different, definitions. In most cases you will see an emphasis on buying shares in undervalued companies. However, Value-Investing is much more than that!
In summary, it’s investing in excellent, well run businesses when the market price of the business falls below the intrinsic value of the business minus your margin of safety.
Over time I have refined my version of Value Investing, taking the best advice from numerous Value Investing gurus and commentators. What follows is what I believe are the four key aspects of Value Investing.
1. Investing in a Business
Before understanding what is Value Investing, you need to remember that when you buy shares on the stock market that you are investing in a business. You are becoming a part-owner, a shareholder, of that business. Check out our Stock Market Explained blog post and watch the short video I made to illustrate this point. Stock investing means that you do not need to be the sole owner or major shareholder of a business. You can buy a piece of the business and share in the fortunes of the company as its value grows. The key to Value Investing therefore is to pick “great” companies that are undervalued.
Before you buy a piece of a business you need to do your homework. You need to understand how the business operates and makes its profit. If you can’t understand the business then how do you know what you’re buying? How will the business grow and increase your investment? You can either learn how the business functions and seek to understand the industry it operates in, or go and find a business you do understand.
Finally, as you are not the sole owner, or a major shareholder, of the business you need to have confidence in the people who are running the business. Do you trust the CEO of the company? Is there a good balance of experience across the board of directors? What’s the remuneration policy for the company’s executives? Are the executives invested in the company (i.e. do they have shares in the business - e.g. if the stock price has dropped recently and the executives have been selling their shares then it may not be a good business to invest in). A great business that is well managed, has a great vision and clear goals, and has a good track record is what you need to look for.
2. Price follows Value
The fundamental principle that makes Value Investing work. The market price for shares in a business can fluctuate wildly over the short-term, but over the long-term the market price will follow the performance of the business. “Mr Market” is very fickle, so the market price for shares will vary according to many factors - not all of them rational ones either! Your “great” business will likely see times where it is unloved, or really loved, by the market. Or, the whole market may be affected by selling and buying sprees, and other outside influences.
The price for shares in the business will be up or down during these times. However, the business will continue to operate and continue to make long-term profits like it always has. Mr Market will eventually catch up and the price of the shares will follow the business’s value over the long-term.
Price is what you pay, Value is what you get is a famous quote by Warren Buffett, a Value Investing guru. In Value Investing we determine the value of the business before determining what we are prepared to pay for shares in it. Wouldn’t you do this if you were buying the business outright? Value Investors benefit from Mr Market’s fickleness in order to take advantage of great buying opportunities.
3. Intrinsic Value
The key to Value Investing is knowing the Intrinsic Value of the business. That is, the value of the business today plus the potential value of the business in the future. This is easier to explain with an example:
Say you like two very similar businesses. The current size and capital value of the two businesses is identical. However, Business A has historically increased its profits by 10% per year, but Business B has been increasing its profits by 15% per year. If both companies are currently trading at $4.00 per share, which business would be better value?
You hopefully worked out that Business B is better value. Business B has a higher Intrinsic Value because its profit increase per year is higher. Business B should provide more long term value than Business A.
That was a really simple example. In the real world there are a lot of factors that affect the intrinsic value of a company, we will touch on this a little more below.
Determining the business's Intrinsic Value
Over the year's I've developed my own method for valuing businesses. The details of which I hope to cover in a future “Value Investing" online eLearning course, as it's too detailed to put on a simple we page. However, I do have an online simplified version of my Intrinsic Value Calculator that you can explore and use right now. The basis of our valuation method is about understanding how the business will increase in value over time and how you will benefit from investing in the company.
Value Investing relies on a number of evaluations to be carried out on the financial results of the company. The example below demonstrates one of the evaluations I do:
The example evaluation shows that if this business was purchased in 2015 and sold after 5 years it would earn an estimated real return of 28% per annum, assuming that inflation averages 3% per annum.
So, you are projecting the future performance of the company based on historical performance and your understanding of their business model. Of course then, the Intrinsic Value is only an estimate. However, as Warren Buffet says: It is better to be approximately right than precisely wrong. This is a fundamental principle of the Value Investing methodology.
If you are not confident in the intrinsic value you estimate then you only need to increase the Margin of Safety...
4. Margin of Safety
Ok, we know the estimated intrinsic value of the business, but investing in any business has its risks. To offset the risks we need to buy the business (shares in the business) at a sufficient discount to its value.
This is called a Margin of Safety. As mentioned above, the intrinsic value we determine for the business is only an estimate, so the level of our confidence in this estimate needs to be factored into the Margin of Safety.
If the business you are analysing is a well known and respected company, and has had many years of reliable performance, then you may choose to have no margin of safety. However, if the business is relatively new with only a few years of historical performance, or its performance has been a bit variable in the past, or its future performance is not assured, then you will likely want to have a large margin of safety.
For example, the ‘required rate of return’ I expect from our investments is 15% per annum (that way you approximately double your investment every five years). So, for most businesses I look for a margin of safety of 15%, sometimes less for really safe, reliable, “blue-chip” businesses. However, for riskier, less reliable businesses I like to see at least a 30% margin of safety. Please note: You will need to work out your own investing criteria that suits your own financial goals and Risk Profile (see the resources page here to download a worksheet to assess your Risk Profile).
Contrarian Investing - the courage to stand by your convictions
Value Investors are often buying when Mr Market is selling. It seems counter-intuitive, but that’s what sets Value Investors apart from the rest of the traders buying and selling on the stock markets. Value Investors have done their homework. They do not follow their emotions. They have set criteria and only invest when value is assured. Value Investing has reliably proved itself over time.
So, primarily a longer-term investing method, Value Investing can be used for shorter timeframes as well. It’s just that the risk of short-term adverse performance affecting your investment is higher, so you need an increased Margin of Safety.