Written by Shivani A. Patel. Edited by Benjamin Landes.
The Value Approach
There are three things that successful value investors always do: 1) remain uninfluenced by emotions such as fear, excitement, or greed, 2) practice the tested patience required to invest for the long term and of course, 3) the required arithmetic. When combined together, these practices will allow you to buy high value stocks, at discount prices. You can consequently sell them in the future at an appreciated price. This approach to the stock market, which been aptly named the Value Approach, has proven to be successful for investors like Warren Buffet. Yet, this incredibly astute method of investing is quickly rejected as “too risky” by many traders who, under the thumb of false logic, believe that cheap stocks are cheap because they aren’t worth more. This is one of the most unfortunate pitfalls of many failed traders; it’s this exact mindset that’s responsible for so many traders buy high and selling low.
“Remain uninfluenced by emotions such as
fear, excitement, or greed”
This “buy high, sell low” phenomenon exists in a staggering magnitude. In almost every market, other than the stock market, consumers are easily able to see the value of buying quality products at marked down prices. However, investors often deem cheap stocks as unworthy investments. Instead of looking at a low-priced company and its’ fundamentals, they end up assuming that a cheap price means a lower quality investment. This can sometimes lead to what is known as panic selling, where investors succumb to their emotions when they see prices fall. They give into the fear and greed that preys on the anxieties and vulnerabilities of the human condition. They become scared of losing it all, so they decide to get out before it’s too late. Our emotions are the main culprits of bound-to-fail investment strategies. That being said, value investing is a most difficult strategy for emotionally-driven investors because they are truly incapable of acting out of reason. Therefore, they are unable to make the significant distinction between a junk stock and an undervalued stock.
The Investor’s Dilemma
During my time as a broker, I realized that the same investors who were prone to emotional overreactions were the same ones who, at the cost of their clients’ money, believed that intrinsic value was expressed through current market prices. These were the brokers that usually bought and sold too often and constantly fell for the media related hype, panic, and rumors. If you are a new player in the market, avoid this investors’ dilemma by detaching yourself from the emotions you may feel due to completely normal fluctuations in the market. This will require long-term discipline and self-awareness since value investing usually means holding on to a stock for long periods of time, until the company reaches its’ full potential.
Before I continue, I want to quickly differentiate between a value stock and a stock that is merely a bad investment. Bad investments, or “junk” stocks, are also cheap, but they are trading at low prices because of problems with the company’s fundamentals. An established retail stock that suddenly dips $20 in price from $62 to $42 dollars, is likely suffering because of the details behind the company’s proposed business model. The only way to be certain of why a stock is selling for cheap is to look into the company’s fundamentals! Do your research. In order for it to be a bargain, a stock must be trading at a discount while the company continues to have solid and healthy fundamentals. This is the difference between a bad investment and a great bargain.
A good investor knows that the price of a stock is what you pay, and the value is what you get. This is the Warren Buffet Way, and a principle taught by the father of value investing, Benjamin Graham. It is in your very best interest to buy stock in companies that carry a great potential for growth, yet are trading at a lower price than their market peers, or the market as a whole.
The Warren Buffet Way
The Warren Buffet approach to investing involves a level of discipline and patience that does not come naturally. You must work at practicing restraint. How often do you hear about Warren Buffet selling or buying stock? Not very often, right? He does not invest lightly, and neither should you. Furthermore, do not invest in value stocks expecting to make a very quick return. Fast money leaves your bank account as quickly as it arrives and this is especially true for investors in the stock market. Any experienced investor will agree that the market is kindest to patient investors who are able to restrain from overreacting to stock market news and trends.
The best way to approach your portfolio is by letting it grow undeterred from unnecessary selling and buying. A wise man once said that investing should be as exciting as watching paint dry or grass grow. In other words, careful investing involves sitting back and letting your money slowly but surely grow. This will require discipline, as you will constantly have to go against market trends. Instead of impulsively selling when everyone else is, your key objective should always be to hold your value stocks for long periods of time. If you plan on making money, you must wait for the company that you invested in to reach its true potential, only then will you be able to sell its stock at an appreciated price that reflects its’ true intrinsic value. Sometimes, this can take many years. You will find that value stocks end up being priced higher within a year, but the price will continue to appreciate even more for many years to come. Therefore, hold your outperforming stocks, through the dips and the panic, and even during your bouts of fear or paranoia. There will be days that your stock is doing astonishingly well compared to when you bought it. You will find yourself thinking, “I can make money if I sell now. What if the price drops and I never get this opportunity again?” Do not give into your greed-driven impulses; value stocks are out-performers in the long run, so wait, wait, wait. You will be rewarded for your patience.
If you are new to value investing, it is important that you lay down the foundations for your portfolio by doing thorough screening and research. To determine whether a corporation has high intrinsic value, it is important to establish whether it has potential. Undervalued stocks often (but not always) belong to relatively new companies who offer products and services in emerging industries. These companies usually have less debt and a high cash flow. If you do the research, you will notice that undervalued stocks that are likely to outperform the market are the same ones being traded at low prices. They remain at discount prices even though they show an increasing amount of growth each quarter, especially in comparison to other companies who offer the same or similar product. These stocks remain at bargain prices until the market finally recognizes their intrinsic value.
A stock’s intrinsic value is determined by examining its fundamentals. Ask yourself these questions: Does this company have more cash flow than it is does debt? Is the company trading at a price to earnings ratio (P/E) that is lower than the industry average? Do the company’s assets amount to at least twice the company’s liabilities? Is this company selling useful products or services that are currently in high-demand, or will be in the near future? Does this company belong to a new industry? Is it currently facing hard times due to the economy or overreactions to price fluctuations in the stock market? Are the company’s market peers selling at comparatively higher prices? Is the price/earnings to growth ratio (PEG) less than 1? If you are researching a potential value stock, and you answered yes to all of these questions, then you should be intrigued and look into the company even further. If you want your portfolio to outperform the rest of the market, you must do the work. It is a tedious process but if you don’t put in the work, you won’t get the results. Screening for value stocks is not as thrilling or as sexy as day trading, but it sure as hell results in higher returns in the long run. If you fail to screen for value, you essentially end up gambling—and, you’re better off chasing that vice in Vegas, not on Wall Street.
All too often, new investors become delusional and end up shopping for stocks in the same way that they would shop for a high-end, luxury car— where expensive prices often times mean better quality. Don’t make this mistake. As Ben Graham once said, “A great company is NOT a great investment if you pay too much for the stock.” There’s nothing to profit from when you purchase stock in a great company once its’ price tag is too high. Therefore, screen for stock in companies with true intrinsic value, not just shares with high market prices. Lastly, always remember that when you buy shares in a company, you become a partial owner of that company. When you invest in the market, your ownership goes beyond a ticker symbol. Be intentional and mindful with your trades—invest in the business, not just the stock. Time really is money in this industry. Every day that you spend without investing undervalued commodities on the market is the equivalent of another day where you lose out on making money. Therefore, in being vigilante about how you choose to spend your time, you become vigilante about your money. As you weave through the complexities of the financial market, be careful not to become a victim of your own emotions. Always remember to be patient with the market. Screen for value by putting in the work and of course, do the arithmetic because at the end of the day, this is nothing more than a numbers game.
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