Value investing is an investment strategy for buying a stock first introduced by Columbia Business School professors: Benjamin Graham and David Dodd. It is a very popular method of investing in stocks. This article discusses why even Warren Buffet uses this method in his selection of stocks.
What is it?
Value investing includes picking stocks that are priced less than their intrinsic value. An intrinsic value refers to the estimated value of the company. This includes analysing its quantitative factor such as the company’s financials and its qualitative factor such as its brand. Therefore, proponents of value investing pick stocks that are considered to be underpriced by the market.
Value investing is based off the belief that the market overreacts to news of a company, irrespective of whether it is good or not. This overreaction results in price fluctuations which does not reflect the true value of the stock. This creates an opportunity for you to buy stocks at a discounted price and profit off this overreaction.
Why would a stock be undervalued?
Efficient Market Hypothesis
The efficient market hypothesis states that the current stock price is representative of the true value of a stock. A value investor does not believe in this theory. They do not believe that the market value of a stock reflects the intrinsic value of a company. They believe that, at all times, a stock is either undervalued or overvalued.
For example, at times of recession, a company’s stock may be underpriced. But this is not because the company is performing bad or its true value falls. Rather, it is because of the investor’s perception of the economy downturn affecting the company’s performance, which may not be true. Similarly, a company’s stock may be overvalued because of its hype.
Most of these stocks that are not covered or noticed by the public will often be undervalued. This is because investors will not be aware of that company and its product, resulting in less people investing in them and lower stock prices.
Stock picking involves a high degree of psychological factors. Most investors do not stick to fundamental analysis. Rather, they believe that when stock prices go up, it is because the company is doing well and everyone is investing in it. However, this herd mentality causes investors to rely on the perceived value of the company and not its true value.
Subsequently, when a stock price goes down, investors usually sell them before it goes down even further instead of holding it and waiting until the price moves up again.
Since value investors buy stocks that are undervalued, there are less risks involved. An undervalued stock can only go up and when it does so, the value investor will gain significant returns.
Value investing is an investment strategy that emphasises on long term gains. As a result, value investors ignore day to day fluctuations. This also leads to lower tax paid and less fees incurred. To read more about capital tax gains, you can visit the ATO website.
Value investors do not rely on their emotions and hype when picking stocks. They look at the financials of a company to determine inherent value of the stocks.
Duration of stock underperformance
The underperformance of a stock might be long. This means that it may take a long time before the stock price moves up. It requires patience.
It takes a lot of time and effort for you to determine whether the stock price is undervalued or overvalued. You not only need to analyse the company’s financials, but analyse the competitors and industry landscape as well to know whether significant growth is achievable.
Value investing is a popular investment strategy. This is because unlike regular investors, value investors buy the company, not the stock. When buying stocks, value investors perceive it as to buying a portion of a company they believe will succeed in the future. Nevertheless, it is good to have various investment strategies to apply it to different scenarios. Subsequently, to minimise your risk, you can contact a business lawyer.