Why Value Investing And Discounted Shopping Have A Lot In Common

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12 Apr 2019

Value investing is defined as investing in stocks that are available at a ‘discount’. Or if we put it in more financial-y terms, a value investor buys stocks that are trading at less than their intrinsic value.

It’s kind of similar to discounted shopping – it’s all about knowing what to buy, when to buy, and bargain hunting for the best deals!

Value Investing In Basic Terms: Buy LOW And Sell HIGH?

Fresh off a Dividend Machines course by the Fifth Person, here’s what I gathered about their take on Value Investing:

Buy stocks like you buy things on discount
Remember that it’s a marathon, NOT a sprint
FOMO is a thing, even in the investment world
Look at simple businesses where there is ongoing demand for its products and services

…amongst several other things.

I couldn’t entirely grasp the concept of Value Investing in one day (#noob), so I went home and sought out more answers to questions. As usual, I started with the most basic question:

“CAN SOMEONE TELL ME WHAT VALUE INVESTING IS IN BASIC TERMS?”

Lo and behold, quite a few people jumped in to share their expertise on this topic. I personally think this answer by Mr Lim Boon Tat deserves some recognition:

It definitely was an *eye-opener* to read how he likened Value Investing to ridesharing.

Tips for Value Investing

Benjamin Graham, the former mentor of Warren Buffet, outlined 7 tips.

Credit
Ratings: Sticking to companies that have credit ratings of B+ or better using the S&P rating system.

Debt/Current Asset Ratio: Graham recommends investing in a company with a ratio of less than 1.10.

Current Ratio: This is simply current assets divided by current liabilities. Graham recommends looking at a ratio higher than 1.50.

EPS Growth: Graham advises to look for stocks with positive EPS growth over 5 years.

P/E Ratio: Graham thinks that we should look for companies with a P/E ratio for less than 9. The reason for this is that the lower the P/E Ratio, the higher the chance the stock may be undervalued. But I would add that you should compare this to other companies. If other companies P/E Ratio are around the same, then the stock may not be undervalued after all, and the converse may be true also.

P/B Ratio: Graham suggests looking at a P/B ratio of less than 1.2. P/B ratio measures how much the market values the share compared to its underlying book value. Like the P/E ratio, this is a gauge of whether the stock is undervalued which should be compared against different companies.

Dividends: Finally, Graham advises to invest in companies that pay dividends.

Below is also another answer drawing reference to The Intelligent Investor by Benjamin Graham. Click to read her full answer.

Common Pitfalls Of Value Investing

Not understanding the Business / Industry itself

I think one common pitfall is not really understanding how the business or industry actually works, so you may not be able to spot certain trends which may show overvaluation or undervaluation. Since value investing is about spotting stocks which the market isn’t correctly pricing, a lack of understanding about the business could lead you to make the wrong judgements about how the stock is being valued.

Wrong Conclusions about High or Low Multiples

One of the ways to spot if a stock is over or undervalued is to compare the stock’s P/E ratio with the rest of the industry. This method is intuitive and very effective at times. However, a low or a high P/E does not always mean that they are valued wrongly. High or low ratios could be caused by firm-specific traits which may not be shared by their competitors. For example, a firm’s share prices may fall because of a major or lawsuit or loss of a key customer, but it could also rise because the firm may have secured certain key contracts or just had an earnings call that they had a strong year. So before an investment is made, it would be good to find out there are other issues at hand.

Other than digging deeper into specific multiples like the P/E Ratio, you can also compare different multiples such as P/B ratio, PEG, P/FCF multiples etc with other industry players to validate your conclusion.

Too Short a Time Frame

Value investing is built on the premise that the market will eventually value the stock correctly, allowing you to make a profit off you spotting the actual valuation of the stock correctly. However, the time frame for this to happen can actually be longer than expected, and there could be many reasons for this. For example, market sentiments, cyclical industries, lack of information could cause the market to react to the intrinsic value of the stock more slowly. So it would be good to wait it out longer since value investing usually requires investors to be invested in the long term.

To add on to that, this response by a community member likens Value Investing yet again to shopping for good deals at a market:

By this point, you should be a little more confident if you should or should not foray into Value Investing. However, say you’re a beginner investor and you’re still at a loss of whether Value or Dividend Investing is for you –

“Should Beginner Investors choose: Value Investing OR Dividend Investing?”

The idea is not to ‘compromise’ per se, but to see Value Investing as higher portfolio growth for LONG TERM goals, and Dividend Investing as regular cash for SHORT TERM/current use.