According to Joel Greenblatt, “the secret to investing is to figure out the value - and pay a lot less.” That is the foundation of value investing. Value investors seek out companies whose stocks are undervalued and invest in them.
Without further elaboration on the matter, this type of investment would seem like a perilous gamble. After all, the whole point of investing is to get significant returns on investment. When an investor buys stocks, they would naturally hope that the value of the stocks would appreciate with time. Now, one may wonder how a value investor can predict whether or not stocks bought at a discounted rate have any potential of increasing to the intrinsic value (the “actual” value as opposed to the prevailing market value) of the company.
First of all, value investors do not invest blindly. Before investing, a value investor goes to work trying to understand a company's value as well as the business they intend to invest in. From the current state of affairs of the company and the competence of the management, a value investor can make educated guesses about its future. Consequently, they can make predictions about the rise or fall of the company's stock based on those and other factors.
Value investors employ various methods to ascertain a company's intrinsic or book value to ensure that it is indeed undervalued. The most common method is the discounted cash flow model. Other methods include earnings before interest, taxes, depreciation, and amortisation (EBITDA), price-to-earnings (P/E) ratio, earnings before interest and taxes (EBIT), and price-to-book (P/B) ratio.
The next step for a value investor is patience, as value investing requires buying and holding value stocks. Holding a stock until the market adjusts to its intrinsic value or takes the stock's price beyond it is the key to reaping the benefits of value investing. Hence, a value investor must be very patient, since value investing is always a long-term investment strategy.
Pioneered by Benjamin Graham and David Dodd in 1928, this entire approach to investing has been tried and tested by notable members of society. Warren Buffet, who happened to be Graham's student, adopted this investment style, along with his modifications to its original form.
During Benjamin Graham's time, it was relatively easy to spot the undervalued businesses. However, the economy experienced a significant change around the time Warren Buffet started investing. He was forced to develop a new strategy, finding companies that were both undervalued and great in the sense that they offered unique services. One would reasonably describe companies like that as having high growth potential.
Value investing has many perks. Unfortunately, not everyone has the patience for it. Plus, it ties up investors' capital for long periods. In addition, it calls for a considerable level of dedication, from thoroughly researching a company before investing in it to staying informed about every consequence related to the company afterward, and monitoring the market price of the stock. These are all important steps to minimizing the risk of the investment.
Disclosure: M&R Investment Management, Inc. ("M&R") is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration with the SEC as an investment adviser should not be construed to imply that the SEC has approved or endorsed qualifications or the services M&R offers, or that or its personnel possess a particular level of skill, expertise or training. M&R mainly provides investment advice to individual investors. All information provided herein is subject to change. Investment advise, and financial planning services are provided by M&R. M&R is not affiliated with any of its custodians, including: Schwab Advisor Services or Pershing Advisor Services.
