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Most would be value investors understand the principles of value investing but falter in the practice. The reason often does not lie in what you know, but more in how you handle your portfolio. The basic precepts are simple – buy a stock if the cost is below the value of the business reflected by each share, and sell the stock when the price received is above such intrinsic value. Value investors should never forget that they are buying a business and always strive to act in the manner a business owner should. Every business has a value – whether it be in form of assets or its ongoing operations and prospects. The key idea is that if we acquire businesses at a cost less than its value, and manage a portfolio of such assets, on average over time the market price will approach or exceed the intrinsic value generating profits for us.
This is not to imply that the returns mostly come from capital gains. On the contrary, there are many good investments where dividends constitute the bulk of profits. As investors, we need to be aware of how we are going to earn the returns we desire. Dividend income is often overlooked. In reality one always needs a consistent income stream in the portfolio
In the past I have written about a method of constructing a portfolio that ensures certain assets will continue to provide steady income that can be used to make new investments or strategic increments to existing holdings. Another benefit of dividends is that they act as a partial hedge against inflation and the fact that over a long term every business loses its competitive advantage (over long investment horizons, a buy and hold portfolio will never generate excess returns on capital gains alone unless dividends are involved)
How Does a Value Investor Invest Anyhow?
We will start by reiterating some basics.
- A value investor often buys a stock that the market is temporarily un-interested in
- A value investor diligently reviews the business fundamentals before purchasing the stock and satisfies himself that the value he is receiving is in excess of the cost
- A value investor expects that the market will eventually realize its folly and re-price the security to match the value
- A value investor does not know when this re-pricing will occur, unless he can pick out a catalyst to force the issue
- In cases where there are no catalysts, a value investor is prepared to wait for a long enough period, confident in his analysis
Although value investing is often considered the same as “buy low, sell high”, low and high are subjective terms. We are mainly concerned with the price/value anomaly, regardless of the price. It is quite possible, and it happens very frequently, that a security that is not a good value at $10/share might become a great value at $15 per share if in the interim period substantially more than $5/share worth of value was created in the business. The price of the stock is irrelevant other than to estimate the undervaluation.
Most investors look at the stock price and price changes to decide to buy and sell and judge their investment success. In my opinion, this is exactly the wrong way to invest.
Investing in this manner will make you a speculator as the decisions you make will be subjective and not rational. Speculators invariably lose money over their investment career.
Timing the market never works with any predictable consistency. Timing for value on the other hand is the same as a knowledgeable buyer acquiring or disposing assets and insisting on most favorable terms. Once a commitment is made to purchase the business, and you know the worth of the business and further value it will create for you as you own it, and you have a very good idea of what price you would ask and get at some time in the future, you will ignore any offers you receive that are not in line with your expectations. As investors, this means that once you buy a stock and you have a very good idea why you bought, you should generally ignore the daily price changes with a vengeance.
Coming back to the first point in this section: A value investor often buys a stock that the market is temporarily un-interested in. Markets rarely become interested in the stock just because you bought it. As much as we all want a quick hit, it is not how reality works. What is more likely to happen is that the un-interest will continue or even deepen. This indifference from the market should be of no consequence to you if you have done your homework.
Value investing by definition is betting against the market. Patience is the key ingredient that makes these bets work out. If you focus on the business and refuse to overpay, the profits eventually take care of themselves.
(Yeah, business fundamentals may change while you are holding the stock and appropriate adjustments will be required. But you won’t know what adjustments should be made unless you are very clear on why you invested in the first place.)
A Typical Value Investing Portfolio May Not be Pretty
A good value investor will win more times than lose. An excellent value investor will have mostly wins with occasional losses thrown in. But this is when you look at the portfolio over time. A snapshot of the portfolio at any given moment of time may show a different picture.
I think of a stock as an investment that takes time to mature. At any instant in time, there are certain investments that have matured, some are in the process, while many are in the beginning stages. However, the price appreciation in a value stock is never linear. When a stock comes back into favor, whether it is due to a catalyst, improved economics or other conditions, new investors come in a herd. This is what is normally referred as a change in sentiment. The end result is, a stock will likely spend more time in your portfolio un-appreciated or with losses, and very little time in green (at which point shortly after it might be sold).
What does this mean?
You need Patience AND Conviction to value invest.
The other thing that throws off most investors is that a value investment portfolio is not only uncorrelated to the market, but it ought to be. Again, if you truly expect and want returns in line with the market, then betting against the market is probably the last thing you should do.
You should always check and compare if your investment process is working properly by comparing with the market returns over an appropriate time period. The appropriate time period is certainly greater than one year. There was a time when Warren Buffett was criticized as having lost his touch. Shortly thereafter the internet bubble burst. Jack Vogel has a great analysis that illustrates the returns deviation between the market and value investing portfolio which I suggest you should read.
Value investing requires Discipline.
Either You Get it Or You Don’t, You Can’t be a Half Way Value Investor
This is a complete change in the mindset for normal investors who take the market price to be correct and adjust their investment decisions to conform to what the market is telling them. I recommend (and I am certainly not the first one to do so), that one should make their investment decisions based on sound analysis and wait for the market to conform, which they eventually will in enough cases to make this profitable. Decisions based on fear or uncertainty (or greed) will turn you into a speculator.
Benefits and superior returns of value investing have been mentioned countless times in studies and press. All you need is Patience, Conviction and Discipline. Good news is that as long as you have Conviction, Patience and Discipline should come naturally.
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