Diversification Is Key To The Success Of The Value Investing Strategy
As with any investment strategy, diversification is a key component of value investing. Diversification is a way to protect your portfolio from significant short-term losses should one of your investments take a nosedive.
By maintaining a portfolio of multiple value stocks, index funds, ETFs, and mutual funds, fluctuations even significant fluctuations in the price of a single asset in your investment portfolio wont have a large impact on your overall holdings.
When getting started, beginners should follow the 5% rule. This is a general rule of thumb that suggests a properly diversified investment portfolio has no more than 5% of its value held up in any single investment and no more than 5% of the total portfolio value tied up in a group of high-risk investments.
For example, if you have $10,000 to invest, you should cap single investments at $500. Moreover, you should have no more than $500 invested across all high-risk investments in your portfolio.
What’s A Good P/e Ratio For A Stock
A P/E ratio that is good for one investor may not be enticing to another. P/E ratios can be viewed differently by different investors depending on their investment objectives, which may be more strongly oriented toward value or growth.
Value investors straightforwardly prefer low P/E ratios. A stock for which the valuation implied by the market is substantially below its intrinsic value is likely attractive to value investors.
Growth investors are more likely to buy a stock with a high P/E ratio based on the belief that the superior rate of earnings growth, if not the absolute value of the earnings themselves, justifies the high P/E ratio.
What Is The Value Investing Strategy
Value investors use tools like price to earnings , price to book value , dividend yield, etc to invest in fundamentally strong companies.
They first study the company’s past financials going back many years. They arrive at a reasonable estimates for future growth as well as the risk factors.
They use this knowledge to make a reasonable future projection of the company’s earnings. They compare this projected value with the company’s current valuation.
If the margin of safety is high enough, they buy. They repeat this process regularly as new information about the business is available.
If the stock price rises far above the future earnings estimates, they sell.
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Read Some Great Value Investing Books
As much as I’d like to, there’s no way I can thoroughly explain how to evaluate the intrinsic value of stocks in a few paragraphs, or even in an entire article. I can, however, recommend a couple of the best books ever written on value stock investing.
Warren Buffett is widely regarded as one of the greatest value investors of all time. Image source: The Motley Fool.
First, The Intelligent Investor by Benjamin Graham is often referred to as the best book ever written about value investing and is a cornerstone of the investment philosophies of Warren Buffett and several other successful value investors. It has in-depth yet understandable explanations of valuation methods to find cheap stocks.
Graham’s other book, Securities Analysis, was actually written years before The Intelligent Investor, and while it is a somewhat more difficult read, it’s a must-read for anyone who wants to thoroughly learn how to analyze value stocks. I’ve often said that The Intelligent Investor is “value investing 101” while Securities Analysis is graduate school for value investors.
In a nutshell, the information in this article will give you a great background when it comes to understanding some key concepts and metrics in value investing. Reading these books will give you the tools to effectively use them in real-world situations.
Determine Your Investing Style
Some investors want to take an active hand in managing their investments, while others prefer to set it and forget it. Your preference may change, but decide on an approach to get started.
- If you’re confident about your investing knowledge and capability, you could manage your investing and portfolio on your own. Traditional online brokers, like the two mentioned above, allow you to invest in stocks, bonds, exchange-traded funds , index funds, and mutual funds.
- An experienced broker or financial advisor can help you make your investment decisions, monitor your portfolio, and make changes to it. This is a good option for beginners who understand the importance of investing but may want an expert to help them do it.
- A robo-advisor is an automated, hands-off option that typically costs less than working with a broker or financial advisor. Once a robo-advisor program has your goals, risk tolerance level, and other details, it automatically invests for you.
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Relative To What Then
When using valuation ratios to figure out if a stock is cheap or expensive itâs more useful to compare to other companies in the same sector, to the market as a whole or to the companyâs own historic ratios. Let’s use MSFT again and take each of these in turn.
The first thing to note is the wide range of P/Es among this selection of US software companies, so using the average is probably our best comparison.
This could lead us to conclude that, on 33x, MSFT is a bit more expensive than the average of our select group of software companies on 30x.
This is definitely more useful than our comparison with NKE, as the companies above have more in common.
Adding a time perspective takes this a bit further. While MSFT looks a little more expensive than this select groupâs average right now, that may not have always been the case.
We can carry out the exact same calculation to compare MSFT to the broader market, represented by an index like the S& P 500.
The S& P 500 trades on roughly 22x, which again would make MSFT more expensive.
We can calculate a ratio of ratios , which would conclude MSFT at 33x is 1.5x relative P/E to the S& P 500 at 22x. This relative P/E is commonly used especially when viewed over time.
As recently as 2015, MSFT traded at 1x relative P/E to the S& P 500. In other words, they both traded on around 21x. That means MSFT is more expensive relative to the S& P 500 today than it was in 2015.
One final remark on relatives.
Value Investing Stock Screener
Now that you have read about value investing, here’s the million-dollar question – Which Indian stocks match value investing stock picking criteria which stocks are the most undervalued?
Indeed, this is a difficult question to answer…but we are here to help you get started!
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Revenue And Earnings Growth
A stock with a low valuation may seem like a great investment. But what if the valuation is low because the company has had a history of stagnant revenue and earnings? Or worse, what if the company has seen revenue and earnings decline over the past several years?
In these cases, low valuations serve as a warning sign rather than a buying sign.
Before making an investment, look at the past four earnings reports at least. The more history you look into, the better off you are. When digging through the earnings reports, look for the companys revenue and earnings growth, or lack thereof.
If you find that the company is relatively stagnant or going backward in terms of revenue and earnings, its time to go back to the drawing board to find another opportunity, because the stock of a stagnating or shrinking business is likely to produce losses over time.
Eps Growth Next Five Years
Earnings per share ratio shows investors the companys ability to produce net profits for common shareholders. This is what drives share prices up, the earnings growth. For investors, a value stock must record growing earnings in the future.
So, value investors look for EPS growth next five years of at least 10%. The EPS growth next five years calculation is based on analysts estimates and isnt always accurate, but it can help value investors to filter weaker companies.
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Buying A Business Not A Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a companyto a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.
How To Find Value Stocks
When learning how to find value stocks, you should consider several factors including P/E ratio, price compare to their peers, volatility, and dividends.
Here are some tips to look out for when investigating each factor to determine if your stock is a value stock:
- P/E ratio: value stocks tend to have lower P/E multiples than other stocks
- Price compared to their peers:Value investors look at where a company’s peers are trading. Companies in the same sector often trade at similar P/E multiples unless there are reasons for some of them to trade at lower multiples than others. For example, companies that are going through some sort of transition might trade at a lower P/E multiple than their peers.
- Volatility: value stocks tend to less volatile than other stocks, although that is not always the case.
- Dividends: Many pay dividends, although not all do.
Tip: Value stocks are generally stocks of companies with lower expected growth which also trade at lower valuation multiples.
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How To Succeed In Value Investing
In order to be a successful value investor, its likely youll need to be patient, analytical and composed. Value investing involves lots of research and critical thinking. It is inherently a long-term investing strategy. This means it wont suit emotional or restless investors or those who dont have the time or resources to work out if a company is undervalued.
Why Would A Stock Be Undervalued
There are a number of reasons a particular stock might be undervalued, including the following:
- Stock market crashes. During market downturns like the one in March 2020, share prices of many companies with strong fundamentals drop. This may be triggered by investor fear and doesnt necessarily reflect a companys performance. But it also means you can buy these stocks at a discount before they rebound.
- General market behavior. If the price of a certain share declines, some investors may panic sell, causing the stock to plummet without justification.
- Unpopular companies or industries. Industries like tech and green energy dominate headlines. This can cause investors to ignore undervalued companies in boring industries.
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The Drawbacks Of Value Investing
Warren Buffett has famously passed on several of the biggest technology stocks this century, because their markets were deemed by the Oracle of Omaha to be too open to competition or difficult to understand.
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High research efforts required
Unearthing value stocks to buy is a tough business, and one that takes a significant amount of time and expertise on the part of the value investor.
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Lack of diversification
Value investments are typically concentrated in specific companies that investors believe offer significant upside at their current undervaluations.
Given the focus on a small selection of names and the difficulty of finding value stocks, investors can be overexposed to a limited number of firms and miss out on the benefits of diversifying their portfolio.
Warren Buffet’s Four Filter Approach To Value Investing
Warren Buffet’s four filter approach is an evolved version to value investing. It is process by which one can arrive at an investment decision while keeping both, the qualitative as well as quantitative factors of value investing.
The approach identifies companies by going through the following four steps:
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How Do Commissions And Fees Work
Most brokers charge customers a commission for every trade. These fees can go up to about $10 per trade. Due to commission costs, investors generally find it prudent to limit the total number of trades that they make to avoid spending extra money on fees. Certain other types of investments, such as exchange-traded funds, carry fees in order to cover the costs of fund management.
The Basics Of Traditional Value Investing
Ben Graham is hailed as the father of value investing. In The Intelligent Investor, Graham proposed and explained a method for screening stocks that he developed to assist even the most inexperienced investors with their stock portfolio selections. In fact, thats one of the major appeals of Grahams value investing approach the fact that its not overly intricate or complicated, and can, therefore, be easily utilized by the average investor.
As with any type of investing strategy, Grahams value investing strategy involves some basic concepts that underlie or form the foundation or basis for the strategy. For Graham, a key concept was that of intrinsic value specifically, the intrinsic value of a company or its stock. The essence of value investing is using a stock analysis method to determine the stocks real value, with an eye toward buying stocks whose current share price is below its genuine value or worth.
Value investors are essentially applying the same logic as careful shoppers, in looking to identify stocks that are a good buy, that are selling for a price lower than the real value they represent. A value investor searches out and snaps up what they determine are undervalued stocks, with the belief that the market will eventually correct the share price to a higher level that more accurately represents its true value.
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Value Investing Can Be A High
Value investing is a high-risk investment strategy that involves buying stocks that are currently undervalued by the market and holding onto them until they reach their full potential. While this strategy can lead to high returns, it also carries great risk. If the stock market were to crash, value investors could see their portfolio values plummet.
What Are Undervalued Stocks
Undervalued stocks are those with a price lower than their real fair value. Stocks can be undervalued for many reasons, including the recognisability of the company, negative press and market crashes.
A key assumption of fundamental analysis is that market prices will correct over time to reflect an assets fair value, creating opportunities for profit. Finding undervalued stocks isnt just about finding cheap stocks. The key is to look for quality stocks at prices under their fair values, rather than useless stocks at a very low price. The difference is that good quality stocks will rise in value over the long term.
Remember, you should always gather the right financial information about a stock youre looking to trade and not make decisions based on personal opinions alone.
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The Bottom Line On Value Stock Investing
For the most part, value stocks are long-established companies that have steady growth rates, stable revenue, and consistent profitability. Value stocks generally won’t make you rich overnight — and that’s not the goal. If you’ve heard the expression “slow and steady wins the race,” it is one of the best ways to summarize the strategy behind value investing.
Take legendary value investor Warren Buffett, for example. Buffett never buys stocks because he thinks their prices are going to rise this month or this year — he buys stocks because he thinks the underlying business is worth more than he is paying, and he’s willing to wait for years for the true value to be reflected in the stock price.
Some of the most successful investors in the world apply these value investing principles to their strategy, and you could use the same methods when constructing your portfolio.
This article was originally published on Fool.com
Next Steps To Consider
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Growth stocks can perform differently from the market as a whole and other types of stocks, and can be more volatile than other types of stocks.
Value stocks can perform differently from other types of stocks, and can continue to be undervalued by the market for long periods of time.
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How To Find Value Stocks: Value Stock Screener Criteria
The stock market could be a fun game if you invest in value stocks and your analysis pays off. Every investor dreams to find that undervalued company to invest in, just to see the stock prices recording spectacular increases. Easier said than done. But its possible.
Extraordinary Gains Or Losses
There are some incidents that may show up on a company’s income statement that should be considered exceptions or extraordinary. These are generally beyond the company’s control and are called extraordinary itemgain or extraordinary itemloss. Some examples include lawsuits, restructuring, or even a natural disaster. If you exclude these from your analysis, you can probably get a sense of the company’s future performance.
However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year, it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also, beware of a pattern of write-offs.
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