The part 2 of value investing talked about factors contributing to stocks’ undervaluation amongst others. In this concluding part, we shall be highlighting on strategies for value investing and its risks. Lets jump right in.
Strategies for Value Investing
To successfully invest in an undervalued stock, one must conduct exhaustive research on the company in question and exercise sound judgment. In order to determine if a company is a good value, value investor Christopher H. Browne suggests looking at the following factors.
- Raising prices on products
- Increasing sales figures
- Decreasing expenses
- Selling off or closing down unprofitable divisions
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In order to forecast a company’s success, Browne recommends looking at the market as a whole as well as its direct competitors. However, most of the time, there isn’t any hard data to back up the claims made in response to these questions.
Investing in value stocks is largely an exercise in guesswork because there are currently no quantitative software programs available to assist in obtaining these answers.
Therefore, according to Warren Buffett, you should only put your money into companies whose products you are already familiar with, whether they be cars, clothes, appliances, or food.
Stocks of companies providing in-demand goods or services are a good option for investors. Although it’s tough to tell when a groundbreaking new product will take off, you can learn a lot about a company’s resilience by looking at how long it’s been around and how it’s handled tough situations in the past.
Insider Buying and Selling
For the purposes of this definition, “insiders” include not only the company’s top executives and board members, but also any shareholder who owns more than 10% of the company’s stock.
When the managers and directors of a company buy stock in that company, it’s a good indicator that things are looking up for the company.
The same logic applies to the 10% stockholder club: if they didn’t think the company would succeed, they wouldn’t have bought so much stock.
However, just because an insider is selling their shares doesn’t mean bad things about the company’s future prospects; the insider may simply need the money for unrelated personal reasons.
However, if insiders are selling off their shares in large numbers, it may be necessary to investigate the cause of the selling activity.
Examine Earnings Reports
Value investors must examine the company’s financials and benchmark them against similar businesses in the same industry.
The annual and quarterly performance results of a company are detailed in financial reports. SEC forms 10-K and 10-Q are used for the annual and quarterly filings, respectively. Companies must submit these reports to the SEC (SEC).
They are available on the SEC’s website and the company’s investor relations page.
Each company’s annual report is a wealth of information. Information on the company’s products and services, as well as its future plans, will be detailed in this document.
Examine Financial Statements
The balance sheet is a snapshot of a company’s financial health. An organization’s assets and liabilities and shareholders’ equity are detailed on the balance sheet.
Cash and cash equivalents, investments, accounts receivable (money owed by customers), inventory, and fixed assets (plant and equipment) are all components of a company’s assets.
Accounts payable, accrued liabilities, short-term debt, and long-term debt are all detailed in the liabilities section. The amount of capital invested, the number of outstanding shares, and retained earnings are all reflected in the shareholders’ equity section.
A company’s retained earnings are like a savings account; they contain all of the business’s past profit. Retained earnings are a sign of a healthy, profitable company because they can be used for things like dividends.
Earnings, expenses, and revenue can all be gleaned from the income statement. Since many businesses experience fluctuations in sales volume throughout the year, it is best to examine the annual income statement rather than the quarterly statements to get a sense of the company’s overall position.
Risks Associated with Value Investing
Although value investing is considered a low- to medium-risk investment strategy, losses are still possible. Several of these dangers and the reasons they can lead to losses are discussed below.
The Numbers Mean Something
When making value investment decisions, many investors consult financial statements. If you insist on relying on your own analysis, double-check that you have the most recent data and that your calculations are correct.
If not, you could lose money or pass up a great investment opportunity. Until you feel comfortable with reading and analyzing financial statements and reports, you should keep learning about these topics and hold off on making any trades.
As a tactic, you could check out the references. These are the notes to a company’s financial statements that can be found in its Form 10-K or Form 10-Q.
The notes that follow the financial statements provide context and detail regarding the accounting practices and results discussed therein. You can get a better sense of whether or not to pass on the stock if you read the footnotes and find that the information they present is either incomprehensible or implausible.
Gains or losses outside the norm
Some things that show up on a company’s income statement should be treated as outliers or extraordinary. This is what we mean when we talk about a company’s extraordinary item—gain or loss—because it was caused by something outside of the normal course of business.
Claims, reorganizations, and natural disasters are all examples of such events. By excluding these, you may be able to predict the company’s future performance.
But do use your best judgment and critical thinking skills in evaluating these matters. A company’s extraordinary item may not be so extraordinary if it has been reported in previous years.
Another red flag is recurring annual losses that suggest the company is struggling financially. Items classified as “extraordinary” are expected to be rare and one-off occurrences. Be wary of repeat write-offs as well.
Neglecting the Drawbacks of Ratio Analysis
A number of financial ratios that can be used by investors to get a sense of the company’s financial health have been calculated and discussed in earlier sections of this tutorial.
Financial ratios can be calculated in a number of different ways, which can be a source of confusion. These factors can change the meaning of the ratios:
- Either pre-tax or post-tax figures can be used to calculate a ratio.
- Estimates are made rather than exact numbers when using certain ratios.
- Earnings per share (EPS) figures for a company can vary widely depending on the definition of “earnings” used.
- Even if two companies’ ratios are identical, it may be difficult to compare them due to differences in accounting methods.
Investing in an Overpriced Stock
For value investors, overpaying for a stock is a significant threat. If you overpay, you might lose some or all of your money. The same holds true for acquiring shares of stock at or near their current market price.
If you buy an undervalued stock, you reduce your exposure to loss even if the underlying company performs poorly.
One of the cornerstones of value investing is to safeguard your capital. This refers to buying stocks for roughly two-thirds of what they’re worth or less.
By not overpaying for investments, value investors hope to reduce the amount of money lost on potentially overpriced assets.
Relying on One Revenue Source
The common belief is that investing in individual stocks is a dangerous venture. Instead, we are taught to diversify our holdings across a number of different stocks or stock indices, increasing our chances of success by limiting our risk exposure to any one industry or company.
Some value investors, however, are of the opinion that even if you only buy a handful of stocks, your portfolio will be well-diversified so long as you pick stocks from a wide range of industries and economic sectors.
Christopher H. Browne, a value investor and investment manager, suggests having a portfolio of at least 10 stocks.
Benjamin Graham, a well-known value investor, recommends picking 10–30 stocks to diversify your portfolio.
However, a separate group of specialists disagrees. According to the authors of “Value Investing for Dummies,” selecting a small number of stocks can help you reap large profits. They say that if you have a diversified portfolio of stocks, you can expect an average rate of return.
This piece of advice is only useful if you have a knack for picking winners, which may not be the case, especially if you are new to value investing.
Listening to Your Emotions
When making financial decisions, it’s hard to keep your emotions in check. Fear and excitement may creep in when it comes time to actually use some of your hard-earned savings to purchase a stock, even if you can take a detached, critical standpoint when evaluating numbers.
Additionally, you may feel pressured to sell your stock once you’ve bought it and the price drops. When investing for value, it’s important to remember that the whole point is to not give in to fear and blindly follow the crowd.
To avoid making a common mistake, avoid buying as share prices rise and selling as they fall. Your profits will be completely wiped out by such conduct. (It’s not a good idea to blindly follow the actions of other investors.
Conclusion
Value investing is a long-term plan. Warren Buffett, for example, buys stocks with the intention of keeping them for almost forever. He once said, “I never try to make money in the stock market.
I buy on the assumption that they could close the market the next day and not open it again for five years.” You will probably want to sell your stocks when it’s time to make a big purchase or retire.
However, if you hold a variety of stocks and keep a long-term outlook, you can sell your stocks only when their price is higher than their fair market value (and the price you paid for them).
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