Oftentimes the stock market overreacts to bad or good news, resulting in either the undervaluing or overvaluing of a company’s stocks. A value investor takes advantage of this situation and profits from buying a stock when its price is greatly deflated.
In fact, two of the most influential proponents of this method are Warren Buffett (the richest value investor still living today) and Dr. Tan Chong Koay (the most experienced Malaysia fund manager). Warren Buffett believes the key to this strategy is figuring out a stock’s intrinsic value before investing.
Dr. Tan is the esteemed founder of Pheim Fund Management and was the earliest fund manager in Malaysia. He has make magnificent investment returns for his clients through many times of recessions in Asia. By applying the simple rule of ‘sell when the market is overvalued’ and ‘buy when the market is undervalued’, Dr. Tan has become a formidable force in the fund management industry.
What is ‘Value Investing’?
‘Value Investing’ is just another term for taking advantage of the market at the right moment. Just like bargain hunters, you basically hunt for stocks that are grossly undervalued based on their ‘intrinsic worth’. In theory, a company’s stock value should be the same as its market price. However, often they are not the same in the short term.
Sometimes price > value (overvalued), or price < value (under-valued). By analyzing its fundamentals and projecting the future profits the business is going to generate in its lifetime, you can estimate whether a company is underestimated in the market or not. If so, you get to buy its stocks at a bargain in the hopes that the market will turn it in their favor in the long run. These value stocks are being sold below their intrinsic value and have huge potential to grow in the future, when the price is adjusted accordingly.
If you look at the chart above, the red line indicates the company’s potential or intrinsic value. In the beginning, due to its low value, the market misinterpreted the situation and quickly under-valued its stock. Value investors wait for this golden opportunity to buy the stocks at a discounted price. They know the company has future growth potential. They then sell their stock when the market price is overvalued, earning them a nice big profit.
Why Value Investing Works
It forces investors to do the unnatural: buy low and sell high. Often, Individual investors under-perform because they buy more when confidence is high and market nears its peak. On the other end, when all news is doom and gloom, people stay at the sideline and are fearful to put money down. This is what separates them from value investors.
Value investors don’t chase recent performance. They are the contrarian and tend to buy more when others are fearful. This is the time when stocks are undervalued (red area in the graph). This is when you can buy great assets at a huge bargain. However, how do you know when the stock is undervalued and its intrinsic value?
This is where margin of safety comes in. It basically means that you are purchasing at a large enough discounts to permit some room for error. Let’s say that you feel a stock is worth $20 but is currently sold at $17.50. Buying at this price will ensure a margin of safety. Just in case your analysis is incorrect, you have a margin or buffer to allow that mistake.
Now look at this simple logic: say every month you need to buy a 2kg soft pack Milo. Price ranges RM32-42 would you buy more at RM32? Would you be happy if your neighbor sells it to you at RM20 for whatever reason? Shoppers will rejoice when Giant or Tesco are selling it at a deep discount, say RM18! They will call their parents, their daughter-in-law, their neighbours and their daughter in Sarawak to ask if the relatives want to stock up more Milo?!
Surprisingly, when established businesses are selling at a deep discount, usually during great recession, everybody shows sour face and ask their friends to stay away from the stock market. If you can spend more time shopping for businesses than you do shopping for clothes, you will be a much better investor.
What are the advantages of value investing?
Unlike active trading that uses technical analysis indicator – value investing can be done in a much bigger scale. Day traders use various indicators from a company’s past to predict its future. They follow various trends like money flow, volatility, momentum, etc. to produce a mathematical chart.
However, a simple fact is certain – WE DON’T KNOW THE FUTURE, unless you create it. If I am not the majority owner of a business and I don’t run the show, it is extremely hard for me to predict its share price.
While on the other hand, fundamentalist investors rely upon old fashioned annual and economic reports. It is the same method whether you are investing RM10k, or RM100k, RM1 million or RM100 million via value investing. At the end of the day, you are simply buying great businesses that is at bargain sale. As long as the company keeps producing profits, you as an investor make money by holding the shares.
This type of investing is quite passive for investors in a way. You might have to hold on to the same stocks for decades, provided that the earnings keep growing. Most people ask about when do you sell a stock? You can keep the good company stocks as long as the company is still making great profits, or you may sell when you find other value buy and you are short of capital to do that. Then you can consider selling your fully-valued or overvalued stocks to deploy your capital more efficiently.
Who Else Are Doing Value Investing?
Benjamin Graham was the mentor to the one and only Warren Buffet and was known as the father of value investing. His more than 60 year old strategy is still used as the bible of investment! Particularly, Graham usually puts his faith in financially sound firms with net current assets greater than its long-term debt.
He also preferred to invest in firms with a well diversified portfolio to evenly spread out risks. However, any company would do as long as you remember his golden rule – ‘margin of safety’.
On the other hand, take John Templeton for instance, who singlehandedly created some of the world’s most successful international investment funds. His mantra about value investing is to search the world for a bargain stock but one with an excellent future outlook.
In contrast, the legendary Peter Lynch, one of the most famous investors worldwide, built his fortune on ‘tenbaggers’. Basically a tenbagger is a company that appreciates its stock value ten-fold in the long run! He had an excellent ability to pick undervalued stocks that are just diamonds in the rough.
Value investing is not sexy. It is definitely boring (because not much action involved). But it works! I run an online course and coaching program on stock value investing called Bursa Method. You can get on the early-bird list here: http://BursaMethod.com
Stock 101 Quiz