Plenty of people shy away from a strategy called “value investing.”
They call it old hat, or even outdated.
But they're wrong.
Value investing is still an extremely lucrative strategy for the investor who's willing to take the time and make an effort to pick their stocks carefully.
Let me explain exactly what it takes to be a successful value investor...
The Buffett Formula
Warren Buffett once remarked, “Investing is simple, not easy.”
There is a big difference between something being simple and something being easy.
In value investing, the simple part is the approach. This is basically buying stocks when they're selling below the underlying worth of the company.
That sounds pretty obvious, right?
It doesn’t take too much brainpower to buy a dollar’s worth of assets for seventy or eighty cents; just buying up the best penny stocks.
That’s the simple part.
The “not easy” part is being able to value the business, then pulling the trigger and actually buying the stock. And many times, the greatest opportunities occur in the midst of fear and panic.
For instance, just nine years ago Lehman Brothers declared bankruptcy and the stock market went into a tailspin.
You could’ve run your finger down the P/E column of the newspaper and found dozens of financially sound companies trading for single-digit P/Es.
During the months preceding the market low in March 2009, there was plenty of low-hanging fruit to pick — financially sound companies that were trading at bargain prices.
If you'd been researching companies at the time, you would have likely gone over your own numbers more than once.
Mr. Market was offering these companies for a fraction of their worth… which many would be right to be skeptical of!
But those bargain-bin prices are just par for the course at market bottoms.
This was especially true after the summer of 2008.
Companies that had rock-solid balance sheets, little to no debt, and overall great businesses were just there for the taking!
But remember: value investing is simple, but not easy...
What separates the great investors from the pack is their ability to stay rational in the face of market turmoil and media drama. They have a keen ability to think clearly and stay unemotional.
When asked to describe what accounts for his success, Charlie Munger, vice chairman of Berkshire Hathaway, said, “I’m rational. That’s the answer. I’m rational.”
It's hard to distance yourself from the hype of the market, but it can be done.
Let's take a look at a few other investors who took this strategy and used it to make their fortunes...
The Masters' Way
Howard Marks is the chairman of Oaktree Capital Group, which has $100 billion in assets under management.
His investment memos were compiled into a must-read book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.
One of his most notable points is one you'll want to keep in mind: “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
So few investors focus on the psychological aspect of investing, though the practice is inherently fraught with emotion.
The last six years have shown investors, once again, that the best buying opportunities happen when investors sell what they have to and not what they want to.
These forced sellers find themselves selling into an emotionally charged panic. It’s at that moment that rational investors are able to pick up the best bargains.
John Templeton was one of the pioneers in the mutual fund industry.
He is known for buying 100 shares of each NYSE listed company that was then selling for less than one dollar a share — 104 companies in 1939 — during the Great Depression, then making many times the money back when industry in the U.S. picked up as a result of World War II.
Obviously not a thing we can all do today, but certainly a show in excellent timing.
His bit of advice for value investors is, “Focus on value because most investors focus on outlooks and trends. You must be a fundamentalist to be really successful in the market.”
Instead of trying to project what the GDP would be next quarter, comparing the unemployment rate for the previous month, or staring down interest rate trends, Templeton focused on the fundamentals of the company, pure and simple.
If he could buy one dollar’s worth of assets for eighty cents, he didn’t need to know much more than that to make an investment.
Seth Klarman is the founder of Baupost Group, a private investment partnership.
Klarman’s book, Margin of Safety, goes for nearly $900 on eBay.
He’s sometimes called “the Warren Buffett of his generation,” because of his straightforward, sound investing strategies.
His main idea: “Once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling.”
The list of billionaires on the Forbes 400 is filled with investors who have made their money buying stocks when they were selling for less than the underlying worth of the business.
Now, my last example for you isn't actually a millionaire investor... he's a baseball star.
Boston Red Sox outfielder Ted Williams was the last baseball player to have a batting average of .400.
In 1941, Williams batted .406, and since then, only four players have hit as high as .390. Many baseball historians say that Williams’s record will never be broken.
You can learn a lot about investing from Williams's winning strategy.
You see, Williams had an analytical mind and was a disciplined hitter. He estimated his batting average in each area of the strike zone, and would swing only when the ball was in the area where he had the highest probability of getting a hit.
This mental map of the batting area looked a bit like this:
He calculated that if the ball were thrown right down the middle — red zone — he would have a .400 batting average. If he swung at pitches in the lower-right or left-hand corner of the strike zone, he figured his average would plunge.
The differential is extreme. In his best zone he hit .400, and in his worst zones he hit just .230, for a difference of .170.
Williams’ approach to hitting is very similar to one common view of value investing: it also involves discipline coupled with analysis.
But rather than a strike zone and calculated swings, value investors use a bull’s-eye and invest in only those stocks that are financially sound and trading at bargain prices.
Any stocks that pass one but not the other criterion, they don’t take the chance on.
But it's worth considering that these aren't the only criterion investors use...
Value vs. Value
Value investors can use any number of statistics to decide the true value of a company. Some include the company's P/E, assets, earnings, and debt.
Still others prefer to look at the market as a whole, and try to predict a company's potential for growth or future profits.
When looking at these different valuation strategies, it's important to keep in mind that you're investing in the company, not just the stock. You'll want a strong company that will last in the long-term.
And this strategy is meant for long-term gains. Value investors aren't day traders.
Rather, value investors look to hold onto a company despite its daily value fluctuations. Ignoring the mainstream media hype is an important part of this strategy.
This is simply because it's too easy for a stock to rise or fall in price or value due to public zeitgeist, or public opinions that don't reflect the true value of the company.
You'll also want to value your own margin of safety. That is, you'll have to be sure you're getting the stock at enough of a discount that there's room for error if something doesn't go according to plan.
And at the end of the day, once you've found financially sound companies, it comes down to the price you pay.
Right now, the market is dangerously overvalued... soon it will be time to start picking these stocks up at great prices.
And it really doesn't matter which way the market moves later on...
As long as you continue to buy financially sound companies that are trading at those bargain-bin prices, you can be confident that you'll keep hitting that bull's eye. All it requires now is discipline and patience.