Value Investing StrategyA value investing strategy involves buying a good company at a cheap price. Then selling it once its stock price reaches fair value. Let’s consider value investing strategy . . .Why value investing worksIf a company falls out of favor with the market, its stock price drops. This gives the value investor an opportunity to buy a position in the company when its share price is low.The question becomes “why doesn’t the market like the company?” Is the problem very serious in nature? Or just some internal problem that needs to be sorted out before the company can return to profitability? If the company has internal problems that can be fixed in reasonable time, we need to see that management is working hard to rectify the problem. Most companies suffer hiccups from time to time. Cyclical companies also provide the value investor with opportunities. By buying into a market sector at the bottom of the cycle and then selling near the top of the cycle, profits can be made. Off course you need to study industry cycles so that you get the timing right. The trick is to get out before the rising cycle starts to reverse. If a company is selling cheap and its upside potential is considerable, it’s only a matter of time before other investors get on board and push the stock price higher. The stock market can be fickle at times and bargain priced stocks do become available. How value investing worksLike other strategies, stock screening can be a good initial approach to a value investing strategy.So can industry analysis. Examine industry cycles to see where we’re at. Where are we in each of the cycles? Which industries are about to resume an upward trajectory? Which cycles look like they’re in the mature stages of a bull market? We’ll avoid sectors that are in bull markets and showing signs of reversing. In order for a value stock to “turnaround” (i.e. return to profitability), the company needs a “strong balance sheet” - plenty of cash in the bank and conservative debt levels. Check this out early on. Once you have a list of candidates perform in-depth analysis on the companies showing the best potential (see the Stock Market Tutorial for more details). Once the stocks are bought, we monitor them regularly. Keep an eye on how the share price is tracking. Read any company announcements regarding our stocks as they become available. Make sure they’re still on track. With a value investing strategy we sell our stocks when:
Tactics of value investingBuy a good company at a cheap price, then sell it when the stock price represents fair value.Study market and industry cycles to get an idea of where we are positioned in the cycles. To screen for value stocks you can start by looking for a company with a high return on capital (ROC) and low price earnings ratio (P/E). Look for a value catalyst. A value catalyst is something that will provide the impetus for the stock to be re-rated by the market. Buy shares in companies that have a history of making money and predictable earnings streams. This also means buying companies that you understand. Concentrate on the factors affecting profitability for this type of company. See what has driven the stock price higher in the past. Examine the key fundamental figures alongside a 10-year stock chart. See if you can find any relevant news items before the stock price rose significantly. Earnings drive stock prices but so too can good news. Act as though you’re buying the whole company, not just a number of shares. The “business owner” mindset is not that far from reality when you consider that share ownership is really ownership in an actual company. The business owner state of mind becomes useful when performing your analysis. Understand that the stock market has an overly emotional personality. At times it’s depressed, at other times it’s optimistic. This is great for value investors. It gives you the chance to buy when it’s depressed and sell when it’s optimistic. Look for a margin of safety. The market capitalization (i.e. number of shares outstanding multiplied by the share price) represents the market value of a company. We can compare the market value of the company to an estimate of what we think the company is worth. The estimation of worth is based on the value of the business assets or perhaps cash flows. If the estimated value of the business is substantially greater than the market value, then you have a margin of safety. The greater the difference between the intrinsic value of the business and the share price, the greater the margin of safety. Put more simply, if the company is worth considerably more than what its current share price indicates, you have a margin a safety. This is one of the things that value investors look for and it gives them peace of mind. Advantages of value investingIf a value stock doesn’t meet its analyst earnings estimates then the stock price doesn’t usually fall that much because the bad news is already built into the share price. Investors who would have sold the stock have already done so.With a value investing strategy you don’t have to watch the market as often as other strategies. Your approach is based on medium to long-term data. A value investing strategy is based on logic and common sense. Value investing has been a consistently winning strategy since the early 1900s. It’s a good strategy for making consistent profits. A value investing strategy can be combined with some technical analysis to boost returns. Disadvantages of value investingSometimes trades don’t work out as planned. Value catalysts don’t work, market cycles might be slow getting started, or the market doesn’t appreciate the potential of the stock.Who uses value investing as a strategy?
Stock market strategies: Fundamental Analysis – the company’s financial numbers and its story Technical analysis – examining stock charts and technical indicators Value Investing – buying good companies at the right time Growth investing – buying companies that are growing fast Income investing – buying companies for their dividends Index investing – buying into a stock market index fund |