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They call it old hat, or even outdated.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...
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.
The Masters' Way
Now, Buffett, while one of the most well-known names in the investing world, didn't actually come up with his winning strategy himself. He had a little help from his mentors...
You may or may not know the names Ben Graham and David Dodd, but the two shaped a generation of investors with this strategy.
In fact, they achieved one of the most difficult things in mentoring investors: creating an approach that not only succeeded, but lasted through decades of investing, and is still referred to today!
That approach was value investing, and it's spelled out in the duo's famous book, Security Analysis.
The book's title pretty well explains Graham and Dodd's main idea: that a secure investment could only be found through thorough and accurate analysis.
One of Graham's biggest assertions was the difference between good investments and speculation. He states in the book, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
The definition of value investing found in Security Analysis encourages investors to focus on the “intrinsic value” of a company's stock, and to ignore the market mania.
At its core, value investing really just aims to find what a company is really worth.
As Buffett notes later, this idea is simple, but not easy.
Graham and Dodd took a rational approach to investing, looking at every angle to get as close to security as possible. Of course, as they admit, true security can't always be reached.
“Any bond can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important... there is no such thing as a depression-proof industry...”
They knew what they were talking about. Because of this, Security Analysis has become a rarity among investing books.
Most books about investing usually have very short shelf lives. They hit bookshelves right at the peak of customer enthusiasm and then quickly lose their relevancy.
But Graham and Dodd's book has stood the test of time. Their value investing strategy may be old, but it's not obsolete by a long shot.
Still sound like a lot of talk? How about a real-life example of this strategy in action?
You'll have to bear with me though; this example 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’ record will never be broken.
You can learn a lot about investing from Williams' 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 bullseye 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 of Security Analysis
Value investors today 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.
Graham and Dodd sum it up pretty simply: “Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants.”
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, with market sectors slipping left and right, is the 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 bullseye. All it requires now is discipline and patience.