In our previous article on value investing, we touch on the foundation and fundamentals of Value Investing. Head on there to follow-up better.
Value Investing Calls for Diligence and Patience
In value investing, the true intrinsic value of a stock must be estimated using both objective financial analysis and considerable subjectivity, making the process at times more of an art than a science.
It is possible for two separate investors to evaluate the same set of company valuation data and come to opposite conclusions.
Some shareholders, who only consider historical numbers, don’t put much stock in projections of future growth. Other value investors look at things like a company’s projected growth and cash flow.
There are those who do both as well: Warren Buffett and Peter Lynch, who managed Fidelity Investments’ Magellan Fund for years, are two of the most well-known names in value investing.
Both men are renowned for their ability to analyze financial statements and valuation multiples to spot instances where the market has mispriced stocks.
Although there are many variations of value investing, they all share the same goal: to make a profit by buying assets at a discount to their intrinsic value and holding them for the long term in the hopes that their price will eventually rise to that level or higher.
The results aren’t noticeable right away. Expecting to make a profit by selling a stock you bought on Tuesday for $100 on Thursday is unrealistic.
If you invest in stocks, you should expect to wait years for a return and should be prepared to occasionally lose money in the process. The good news for most investors is that long-term capital gains are taxed at a lower rate than short-term investment gains.
You need time and effort to see your investment philosophy through, as is the case with any financial plan. Although the fundamentals may be strong, the price of a stock may make it unwise to invest at this time.
If no stocks meet your criteria, you’ll have to sit tight and let your money accumulate some interest while you wait for the right moment to make a purchase.
Factors Contributing to Stocks’ Undervaluation
If you don’t buy into the efficient market hypothesis, you can look for signs that certain stocks are selling for less than they’re worth. The undervaluation of a stock can be attributed to the following causes.
Price Fluctuations and Herd Mentality
Investors can act irrationally at times, putting more weight on their emotions than the underlying market data. They tend to make purchases when the market or the price of a particular stock is on the rise.
Investors experience FOMO when they realize they could have earned 15% more if they had put their money to work 12 weeks earlier.
Loss aversion, on the other hand, causes investors to liquidate their holdings when stock prices fall or when the market as a whole experiences a downturn.
Therefore, they accept a certain loss by selling instead of keeping their losses on paper and waiting for the market to reverse course.
Such widespread investor behavior has an impact on stock prices, amplifying both up and down market movements and creating excessive moves.
Crash of the Market
A market bubble is the predictable outcome of an absurd market peak. However, investors panic and sell in large quantities because the levels cannot be maintained.
The stock market plunges as a result. This is what led to the bursting of the dotcom bubble in the early 2000s, when the price of technology stocks skyrocketed. A similar event occurred in the mid-2000s, when the housing bubble burst and the market crashed.
Stocks No One Pays Attention To Or Cares About
Don’t believe everything you hear on the news. Small-cap and foreign stocks, which are often overlooked, may present excellent investment opportunities.
Most financiers would rather put their money into a fledgling tech company or an up-and-coming social media platform than an old-school producer of consumer goods.
Herd-mentality investing is more likely to affect individual stocks like Meta (formerly Facebook), Apple, and Google than it is to affect large conglomerates like Procter & Gamble or Johnson & Johnson.
Bad News
Companies of all quality are susceptible to problems like product recalls and legal action. A single setback does not negate a company’s underlying value or prevent its stock from recovering in the long run.
On the other hand, a company’s bottom line could take a hit due to a particular business unit. However, this could change if the company decides to sell or shut down that division.
Investors often sell when a company announces earnings that are lower than analysts’ expectations, even though analysts do not have a great track record of predicting the future.
However, value investors who can look past the downgrades and negative news will be able to purchase shares at even lower prices because they will have a better grasp of the company’s true long-term worth.
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Cyclicality
In business, cyclicality refers to the ups and downs that are inevitable. Whether it’s the changing of the seasons or the ebb and flow of consumer sentiment, companies aren’t immune to the cyclical nature of the economy.
Profits and the stock price may fluctuate as a result of these factors, but the value of a company as a whole will not be affected.
Stay tuned for more on Value investing in our next article.
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