Value Investing Strategies and How to Manage Risk

Value investing is a strategy of picking and investing in stocks that trade below their intrinsic value or book value. Value investors work hard to actively uncover stocks they believe the stock market is undervaluing.

When a stock is undervalued because it overreacts to bad or good news in the market, or does not react at all, you may get the chance to buy it at a low price.

Today, the best-known value investors include Warren Buffett, Benjamin Graham (Buffett's professor and mentor), Charlie Munger, and Christopher Browne (Graham's student).

• Value investing is a strategy of picking and investing in stocks that trade below their intrinsic value or book value.
• Value investors need to actively seek out stocks they believe the stock market is undervaluing.
• Value investors use financial analysis and invest long-term in high-quality companies, regardless of what the general public is feeling.

Understanding Value Investing

The basic idea of value investing is simple. Let's think of it with an everyday comparison. If you know the true value of something, it's great to recognize when you have the chance to buy it at a discount. It's the same logic as buying the exact same TV during a sale.

Value investing in stocks works much the same way. Even if a company's value stays the same, its share price can move up and down. Value investing means buying a stock at a discount when it trades below what you believe its true value is, and then waiting. If you're good at finding value stocks, you can reap big rewards over the long term.

Market Inefficiency

Value investors do not believe in the efficient market hypothesis, which says that share prices already account for all information about a company and that the current price therefore reflects the company's value. Value investors think the market can overvalue or undervalue many stocks for a variety of reasons.

For example, a stock's price may be undervalued when the economy is weak or when investors panic and sell their shares. Or a stock's price may be overvalued when investors get excited about new technology and overbuy, as happened during the dot-com bubble.

Intrinsic Value and Value Investing

In the stock market, a stock whose price is lower than its intrinsic value is said to be undervalued. Value investors aim to profit by buying stocks they judge to be cheap.

Value investors use a variety of metrics to try to find a stock's value and intrinsic value. Assessing intrinsic value means combining financial analysis, such as financial performance, revenue, cash flow and profit, with the company's fundamental factors, such as its business model, branding, target market and competitive advantage (link).

The most common metrics used in valuation are as follows.

• Price-to-book ratio (Price to Book), or book value: A metric that measures the value of a company's assets and compares it with the share price. If the share price is lower than the asset value, the stock is undervalued, provided the company is not in financial trouble.
• Price-to-earnings ratio (Price to Earnings): Uses a company's results to assess whether its earnings are properly reflected in its share price.
• Free cash flow: The cash a company generates after subtracting the costs needed to run its business from its revenue. When a company generates free cash flow, it has room to invest in developing its business, pay down debt, pay dividends to shareholders and buy back its own shares.

On top of these, there are many other factors used in analysis, such as debt, equity, sales and earnings. After reviewing these metrics, if you believe a stock is at an attractive price that is undervalued relative to the company's intrinsic value, you can buy it.

Risks of Value Investing

Value investing carries less risk than other investment strategies, but there are a few reasons you could still lose money.

First, the financial statements may not be up to date, or the calculations may be inaccurate. If you can't analyze financial statements accurately, it's better to hold off on value investing and study more.

You also need to be able to spot exceptional or unusual items in a company's income statement. Think critically, use your judgment, and aim to be as objective as possible.

Finally, it can be risky to fall in love with a single value stock and fail to diversify your portfolio. Value investors are generally advised to hold at least 10 stocks.

Managing Value Investing Risk with a Margin of Safety

Value investors need to account for errors in their own estimates of value. Value investors often set their own "margin of safety." A margin of safety is one of the keys to successful value investing: you buy a stock only when you believe it is significantly undervalued relative to its intrinsic value. With a well-set margin of safety, you can limit your losses even if the stock doesn't rise as much as you expected.

Here's an example of a margin of safety. Say you bought a stock worth $100 for $66. If the share price rises to its true value of $100, you make a $34 profit. And as the company grows, the stock's value may rise even higher, earning you more. But if you had bought the same stock at $90, you could only make a $10 profit.

Here, each potential profit is the margin of safety. To sum up, when the current price is low compared to the intrinsic value and you expect a larger profit, the margin of safety is high.

Benjamin Graham, the master of value investing, advised buying a stock only when it trades at two-thirds or less of its intrinsic value. By setting this margin of safety, Graham was able to reduce his risk of loss and improve his chances of profit.

Value Investing Takes Diligence and Patience

To succeed at value investing, you need plenty of research along with plenty of waiting.

Assessing intrinsic value inevitably involves a good deal of subjectivity. Different investors can value the same company differently. You also need to consider a company's growth potential and expected cash flow, then wait until these show up in its results and the market produces the share price movement you're looking for.

Renowned value investors Warren Buffett and Peter Lynch are skilled at analyzing financial statements and spotting cases where the market is mispricing a stock. They have built enormous wealth, but they didn't get rich overnight.

As with any investment strategy, value investing requires you to establish your own philosophy and have the patience and diligence to stick to it. Even if a company's strong fundamentals make you want to buy, you should wait if the price is high. To buy at the right moment, wait until the price becomes attractive, and keep cash ready for that moment.

Wrapping Up

Value investors tend to move against the crowd, reject the efficient market hypothesis, and often sell or sit on the sidelines when everyone else is buying. Value investors don't buy trendy stocks, because they're usually expensive.

Instead, they invest in companies with sound finances, even if those companies aren't well known. And when a company's share price has plunged, if its fundamentals are solid and the quality of its products and services is still excellent, they believe it can overcome its difficulties and take another look at it.

Value investing cares only about a stock's intrinsic value. Value investors try to buy stocks based on their real value. They want to become shareholders by buying stocks in companies they believe are good businesses.

When Warren Buffett buys a stock, he buys it planning to hold it practically for life. Buffett says, "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." This is an important maxim for value investors to keep in mind.