How to invest like Warren Buffett? Consider value investing.
Value investing is considered by many to be one of the most effective ways to build long-term wealth.
The viability of value investing as a wealth generation strategy has been proved by many high-profile investors — from Benjamin Graham, the father of value investing, to his protege bu and many others.
What is value investing?
Value investing is a stock picking strategy wherein you select stocks which you believe are more valuable than what they are trading for.
In other words, you only pick those stocks which you think are undervalued by the market — “mispriced,” to quote Buffett.
Value investing is diametrically opposed to the concept of efficient market hypothesis (EMH), which states that the price of a stock is decided by the market and is truly indicative of the company’s intrinsic value.
Proponents of value investing disagree with EMH and say that the market often is not a fair judge of a company’s intrinsic value. In their view, investors often are irrational and make investment decisions based on short-term fluctuations rather than long-term factors.
How value investing works
Value investors believe that the market has the tendency to overreact to good news as well as bad news.
The average investor does not understand the true value of the stock they buy or the company they invest in. If there is a slide in the market, they tend to panic and sell even high-value stocks at a cheap price, just to limit their short-term losses.
Value investors take advantage of the irrational behavior of the market by buying stocks that are selling at a bargain price compared to their intrinsic value.
Value vs. just “cheap”
It should be noted that value investors do not buy stocks that are cheap, only those that are undervalued.
The difference between a cheap stock and an undervalued stock depends on the fundamentals of the company which issued the stock.
Let us say there are two companies — A and B — whose shares are trading at $20 each.
A is a solid company, headed by able leadership, has a healthy debt-to-asset ratio, and has strong fundamentals.
B, on the contrary, has weak leadership, has an unhealthy debt-to-asset ratio, and has reported poor earnings for several quarters.
Now, between the two, a value investor will always choose Company A’s stock over Company B’s, since the former is currently undervalued but has potential for long-term growth.
The latter, stock B, is likely to decline in value due to the lack of strong fundamentals.
Investing in a business vs. trading shares
Value investors stand out from the rest in terms of their approach towards investing. They buy stocks so that they can become an owner of the company.
They generate wealth by investing in companies with long-term potential, not through stock trading.
Value investing, by its very nature, is a strategy that is designed to bear fruit in the long term. This is why value investors are only concerned about the true value or worth of the company they are looking to invest in.
They do not focus too much on market volatility or stock price fluctuations, as these factors do not have any impact on a company’s long-term growth potential.
How to find value stocks?
There are several factors you need to consider while looking for value stocks in which to invest.
The company’s stock should be undervalued by at least 30% or more. If you think that the intrinsic value is somewhere around $50, the share price should be in the range of $30 to $35.
Price-Earnings (P/E) Ratio
The company’s P/E ratio (market value per share divided by earnings per share) should be lower than the industry average.
Price-to-Book (P/B) Ratio
The company’s P/B ratio (current price per share divided by book value per share) should be lower than the industry average.
Price-to-Earnings to Growth (PEG) Ratio
The company’s PEG ratio (P/E ratio divided by earnings growth rate for a particular period of time) should be below one.
Debt-to-Equity (D/E) Ratio
The company should have a low D/E ratio (total debt divided by shareholders’ equity). There is, however, an exception to this rule.
In some industries, high D/E ratio is extremely common and is usually not considered a sign of a company’s financial instability. Compare the D/E ratio of companies from the same industry to determine which one is the best choice.
Earnings Growth Rate
The company’s average earnings growth rate in the past 10 years should be 7% or higher.
The company you choose to invest should pay dividends on a regular basis. The undervalued stock you buy might take a few years to grow in value and become profitable.
In the meantime, you keep collecting the dividends. Ideally, the company’s dividend yield should be at the very least two-thirds of the current AAA bond yield.
Invest in businesses you understand
The golden rule of value investing is that you should only invest in businesses that you understand. Warren Buffett and his partner Charlie Munger call it their “Circle of Competence.”
There is no point in calculating a company’s P/E ratio or D/E ratio if you do not know how the company actually makes money, what makes it stand out from its competitors, and the overall dynamics of the industry.
Assessing the true, intrinsic value of a company’s stock can be a challenging task due to the dynamic nature of the market and the large number of variables involved.
Moreover, the very concept of value can be subjective, since no two investors think alike.
Two people could arrive at two different values based on the exact same information. So, a safety margin becomes necessary in such cases.
For example, if you think that the intrinsic value of a company’s stock is $45, you should use $40 in your calculations.
This way, you have a safety net to fall back on even if the stock does not increase in value as much as you expected.
Be a proactive investor
Value investing is not a passive strategy. You need to be up to date on the latest developments in the industry, the performance of the companies you are tracking, overall market conditions, and many more factors.
If there is an undervalued stock you should first try to find out why it is undervalued.
Is it due to bad PR? Is it due to a market correction or crash? Is it due to the company’s below-average quarterly reports? Is it due to a geopolitical crisis?
You need to consider all these possibilities, make sure that the company has long-term growth potential, and then make an informed decision.
Being proactive, acting like an owner, is the hallmark of a value investor and the key to building long-term wealth.