For business owners or individuals with excess funds, investing in stocks is often a better option than keeping cash in the bank. With this in mind, there are various investment strategies available which can enable you to obtain the best stocks to provide the highest returns.
One such investment strategy is value investing. This philosophy involves you buying shares that are trading at less than their intrinsic value. There could be many different reasons why the stock price may be less than the intrinsic value. Perhaps a temporary hiccup in the business caused a reaction in the market that was more than deserved. In other cases, there may be real competitive pressures that you may believe the company will overcome, but the market may not carry the same belief. In other cases, you may have a better insight in the business or the valuation than the rest of the market. No matter the reason, the outcome is that you are able to buy the stock at a discount to the correct value, and you are convinced that the market will eventually realize its mistake and increase the stock valuation thus handing you the profit.
With this strategy, it may appear that you’re making money due to the impatience of fellow investors. The trick is to estimate a stock’s intrinsic value before buying. However, this is not an exact science, it is more of an art. Two different investors can obtain the same information about a stock but arrive at completely different conclusions.
If you want to increase your chances of finding undervalued stocks, here are some tips worth remembering.
Know the Business
Before buying a company’s shares, consider researching how it makes its money. What kind of products or services does it sell? Is it a local or international business? Is it the first or last in its industry?
Such information is easy to find online, just type the company’s name into a search engine and go directly to the website or read any positive/negative feedback about the business.
Also, consider looking for red flags about a company you want to invest in. For example:
- Has hardly made a profit since it began operating
- Share prices are constantly dropping
- Has a lot of debt
- Under serious investigation
It is surprising that how few investors actually do a very basic research on the business and try to understand what the company does.
A good basic understanding of the business immediately puts you far ahead of the majority of the investors (including institutional investors, such as fund managers). However, you are not done yet.
Next you should take your knowledge and research the industry and the market and the company’s position in the market. A market leader generally commands better profit margins and return on equity. This will help the company enjoy above average profits for years to come. A SWOT framework is a very handy tool to evaluate a company’s market position.
Looking at your stocks as pieces of businesses you own will help you view things in a different light. You will be able to focus on news and events that are material and ignore the news and events that are just market noise. This will help you make better investment decisions.
Consider the Key Financial Ratios
We are probably very familiar with the P/E ratio. Price to Earnings ratio gets a disproportionate press compared to its actual usefulness as a valuation metric. It is always a good first check, but a serious investor (meaning you) should look much deeper than a cursory glance at the P/E ratio.
For most value investors, book value carries more meaning than earnings. Past earnings are already reflected in the balance sheet and will show on the equity line (book value). Future earnings are merely estimates and are subject to everything going just right according to our assumptions (normally, they won’t). So while earnings based ratios can be indicative, they are not always the best places to start your valuation exercise.
In addition to valuation ratios, it is important to understand how the business operates and is funded. Does the company make good use of its debt? Is the capital structure optimum? Does the company collect payments on time? How do they handle inventory? I have listed 17 key fundamental ratios that you should look at when you are assessing a company for investment.
Valuation is an Art
Value investors come from many different backgrounds. They focus on different factors of value, and may assign different weights to what is important. As a result, every value investor has his own assessment of intrinsic value and it likely differs from others.
So who is right?
Perhaps they all are.
It is possible that everyone differs in their estimates and make make different investment decisions on the same stock, but they all end up profitable.
Other than a few basic rules and benchmarks, valuation tends to be not an exact science. Being precise is not as important as having a view about the investment, and then having a process to execute on that view. The correct process will ensure that if your view is correct, you will make profits. If your view on the other hand turns out to be incorrect, the process needs to ensure that your losses are minimized. Over time as you do this more and more, you will learn from your mistakes and fine tune your processes.
You will create a system and develop a coherent set of value investing philosophy of your own.
Manage Risk in Your Portfolio
As part of buiding your investment process, you will realize that the rate of growth of your portfolio depends on you minimizing your losses. Avoiding capital losses is the main goal of managing portfolio risk.
Value investors have evolved such constructs as Margin of Safety, Net Current Asset Value, Liquidation Value, etc to ensure that we do not overpay from any security. Additionally, further risk management can come from hedging and exit strategies.
Size Your Positions Correctly
Not every stock in your portfolio deserves an equal number of dollars allocated to it. Warren Buffett often talks about his job as being that of a capital allocator. He has not disclosed how he allocates capital properly. Here is one well designed capital allocation method.
Intelligent position sizing will maximize your portfolio growth and minimize your risk at the same time. Random position sizing can shrink your portfolio, even if you invest in the same stocks (just different proportions).
Sadly over 90% of the investors do not understand how to size your positions properly.
Value investors make money by waiting for their stocks to be recognized and valuation corrected by the market. This can be a long wait. Time increases impatience, which makes it risky. A little bit of cash flow makes this wait so much easier and may I say, exciting.
Dividends therefore can help you be a better value investor.
Dividends also serve a few other functions. A company that pays a regular dividend generally is a more shareholder friendly company and will likely make decisions that are good for you as a shareholder. A regular dividend also ensures that the company has a real cash flow to support this dividend. And finally, a dividend can be reinvested in this (or preferably a stock that is the most undervalued in your portfolio), and this can start a compounding effect that will accelerate your portfolio growth.
Value investing requires deeper due diligence as well as the right approach to investing. Any one can cultivate these skills and approaches, but you have to put in the time and be willing to learn by doing. Mistakes are inevitable and will bring many lessons. As you learn, look for other successful value investors to help and guide you along the way.
Go here for more detailed information about how to invest in stocks for beginners.
About the Author
Nishi Patel is the founder of Northants Accounting. He started his own company after a successful career in management accounting and financial analysis. His company helps small business owners with accounting, tax planning, cash management and identifying business opportunities. You can research a list of popular accounting tools that can help you manage your business and investments.