Value Investing: Buying Stocks on Sale
Investment styles are as diverse as fashion styles. What you consider comfortable and fashionable is different than the next person… so the variations on traditional, everyday wear is limitless not to mention the extreme fashion options embraced by the fringe! But let’s face it… most of us have a pair of blue jeans, a t-shirt, and running shoes in our wardrobe. Similarly, while investment styles are as personal as your choice of clothing, we all tend to lean toward one of three traditional investment strategies, namely:
Today, we’ll explore value investing… an investment strategy dating back to the 1920s which continues to have an extremely loyal following today.
What is Value Investing?
Value investing is a way of classifying the ideas of Ben Graham and David Dodd of Columbia Business School dating back to 1928 and popularized through the publication in 1934 of their book, Security Analysis. While the ideas have evolved over the past hundred years, the fundamental principles have not. At its heart, value investing is buying quality securities whose value appears underpriced.
Find an outstanding company at a sensible price, not a generic company at a bargain price.
It’s like going shopping for a quality piece of steak… you know the typical price of steak and can identify a quality cut of meat. So, when you’re walking through Costco one day and see the supplier standing in a booth promoting that rare piece of quality steak on sale, you buy it because of its intrinsic “value.” After all, the steak is of higher quality than the competition and at a lower price than not only the competition, but lower than what you typically find it at Costco for… due to the special supplier’s sale!
When it comes to stocks, value investing is buying a quality stock at a price that appears undervalued by the markets. In terms even investor “dummies” can understand, it’s buying a stock on sale! Of course, what is a sale to you and what is a sale to me is different because we value things differently.
For example, let’s say you see a stock trading around $50 per share for the past several months. With a little research you discover the companies fundamentals are stable and their growth looks dependable in both the short and longer term. When I do my research, I determine the same thing, although I notice their revenues are increasing each quarter at a faster rate than anticipated. So, I may just purchase the stock today… at around $50 per share… believing it is undervalued in light of its anticipated value in the future (usually longer term). You, on the other hand, wait… and refuse to purchase it until it meets your criteria of a sale… which would be $45 per share. Of course, it may never reach $45 per share… and so you move on to the next deal not seeing enough value in it at the current $50 price point. Both are examples of value investing… the difference comes in the way investors determine quality and value.
Value Investor Warren Buffett
Value investing is one of the most popular investment strategies, due in large part to the chairman of Berkshire Hathaway, Warren Buffett. Using Graham and Dodd’s seminal work Security Analysis, Buffett referred to it as his “investment bible.” Yet, like any good investor, he has adapted the principles of value investing to suite his personality, principles, and aspirations as an investor. Nevertheless, certain principles remain constant including:
Margin of Safety – A term Graham used to describe the discount between the market price and what the investor believes to be the true intrinsic value. It’s like a built in safety net. For example, let’s say you buy an item on sale at a garage sale knowing you can sell it at a premium on Ebay the next day… the difference would be your “margin of safety.” Although for Buffett, and most other value investors, value investing is not a short term trade but a long term purchase to be tucked away for a while.
Quality Stocks – But price isn’t everything and cheap doesn’t mean better. Value investors are fundamentalists at heart… dissecting the core financials of the companies. Most commonly, value investors look for companies whose shares are trading with low price-to-earnings multiples, may have high dividend yields, or may trade at a discount to their book value. But any stock will not do… value investors look for the best quality stocks at cheap prices. After all, garbage will be discounted all the time!
Beware of the Value Trap
I would like to think that all of us are “value investors” to some degree. After all, who wants to buy stocks that are overpriced with weak fundamentals? To me, that approach is more characteristic of a gambler than an investor. Nevertheless, there are some who get so excited by the “sale” that they forget to consider the quality of the product. This is a classic “value trap.”
A value trap is a stock that appears to be cheap, causing investors to purchase shares, only to be disappointed by the share price continuing to fall. Sometimes, the low multiples of earnings, the increased earnings per share, the cash flow or a variety of other fundamentals you might use to determine value simply points to a decline in quality, not a valuable opportunity for investors. Investors who “double-down” or buy more as a stock price depreciates, believing the value is even greater than when the stock price was higher, are subject to the classic “value trap.”
So, how can you take advantage of value investing without falling prey to a value trap? That’s where “Growth Investing” comes in… and we’ll take a few moments to look at it in our next article.
In the meantime, if you’d like to learn more or perhaps read the book Warren Buffet described as his “investment bible,” check out my resource link to the right where you can purchase it through Amazon! And be sure to leave a comment below sharing your experiences as a value investor… after all, we are all value investors of some sort… looking for quality stocks at discounted prices!
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