Value InvestingWhat is value investing? Value investing is investing in companies whose prices are well below their book value. Book value is all assets of a company minus its liabilities. These assets include fuzzy things like brand that make book value a bit sketchy sometimes. How valuable is the Coca Cola brand? Certainly, it is worth a lot, but it is extremely difficult to put a number to it. That number will be a rough estimate at best, but companies must do it. There is an investing metric that makes it easy to know if a company is considered "value" -- P/B or price to book ratio. Preferably, the P/B will be well below 1. There are people who calculate the P/B themselves by taking out the fuzzy values from a company's book value. This is helpful and if I were to consider investing directly into a company that got flagged as value, I would do it to be safe. If the fuzzy values are removed and you still have a P/B less than 1, then it looks pretty good. There are more due diligence steps, but this is a first, big one. Where did value investing come from? Value investing was started by a man named Benjamin Graham. He was Warren Buffett's mentor and author of some great investing books -- including what I and many others consider to be the greatest investing book ever. Graham and Buffett both had long, successful investing careers. Graham viewed these companies as extremely low risk because, if push came to shove, you (well, not you, but the company) could always sell their assets off for their cash value and make a profit on your money. In fact, this is what often happens via another company buying the value company for its assets while the price is well below the value of the assets. Furthermore, this is what Warren Buffett does all the time and what he did with Berkshire Hathaway many moons ago. Why would you participate in value investing? Graham had a great saying that exemplified his investing principles: "Price is what you pay. Value is what you get." Just because a company has an extremely low price, does not mean that is what its true value is. Big swings in the market don't necessarily mean big swings in value. Ultimately, you buy value companies for the same reason you buy something at the store when it is on sale -- it costs you less for the same amount of value! When bananas go on sale at the store, do you buy more or less (or the same)? When the price of bananas doubles, do you buy more or less (or the same)? Think about stocks the same way you think about saving money at the grocery store -- lower price is better than a higher price. People's instincts with regards to stocks tend to take them in the wrong direction here. Don't let your primal brain take over! Value companies have a high "margin of safety." Benjamin was always looking for companies with a high margin of safety. The higher the margin of safety, the more wrong you can be about your assessed value and still make money. For example, a company with a P/B of 0.95 most likely has a lower margin of safety than a company with a 0.50 P/B. Even if the true P/B of the second company is 50% higher (at 0.75), you're still coming out ahead. However, with the first company, if the P/B is even a little bit off, there goes your potential profits. There are other ways to have get more safety margin, but having a low P/B is the easiest to find. Why would the price not always reflect the value? Often times investors or investing institutions overreact to bad news. Therefore, they create an attractively low price on a company. The overreaction works in concert with the fact that many mutual fund managers "play it safe" by doing the same exact things that other mutual fund managers do. Therefore, when a few managers sell a company, almost all end up selling it and you get a huge swing downward in price. Other times a company has lost money for quite some time. Therefore, their value has been diminishing over time. This is a legitimate reason to be skeptical of a company's value. If it continues to lose money, its book value will continue to drop. However, as I said before, these companies often get bought up by other companies who can utilize their resources. What are the best ways to value invest? The easiest and most prudent way is through index funds. You can easily, for a very low price, buy a broad value index fund and a small value index fund from Vanguard at very low expense ratios. There's good data to show that the small value index fund outperforms, in the long-run, most, if not all, other index funds. It has larger swings in value, so you have to be more patient and less panicky than most people. If you insist on buying stocks individually, make sure you do your due diligence. Simply having a very low P/B is not good enough to buy stock in a company. Many of the times there is a good reason for the low price and you should stay away. If a company is about to declare bankruptcy, then its price should be low. There are many other reasons for a legitimately low price. Again, however, there are many bad reasons for a low price in a company. Which is why Graham and Buffett have been able to buy value companies for profit for a long time. A great example of what could happen with a company with a low P/B is Buffett's own Berkshire Hathaway. He bought much of the company over a long period of time (I think 10-20 years) due to the fact that it continued to have a low P/B. Its price was so low relative to its value because it was becoming increasingly difficult to increase profits -- or even keep the same -- in the textiles industry. After Warren took controlling interest, he took much of the assets in the company and, slowly over time, liquidated them to invest elsewhere where there was more promise for profits. Eventually, Berkshire Hathaway had no part in the textiles industry -- originally 100% of its business. All the original value of the company had been converted over into greener pastures. You can find value stocks through stock filters called stock screeners. I like Yahoo's stock screener. return from value investing to Index Funds |