There are many strategies for investing in the financial markets, and among these different strategies value investing is beyond doubt one of the most popular ones. This approach is a favorite of many big names in the financial market circles, including Seth Klarman, David Dodd, Charlie Munger, Warren Buffett, and others. Given the fact that so many capital market veterans rely on value investing as their primary investment method, it is natural for one to wonder why value investing even works?
Value investing works because it is based on unearthing value assets and buying them when they are cheaper than they’re worth. Such investments are usually safer and always have the possibility of outsized returns. Investors are also in control of their holdings every step of the way.
In this article, we will go into more detail on the top five reasons why more people are adopting the value investing approach, and finding success in implementing it. So, without further ado, let’s dive in.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Value Investing?
Value investing is a strategy that involves picking assets that are trading for less than their book or intrinsic value. It was first seen in the stock market but is now popularly used by traders and investors in other markets as well. Value investors painstakingly fish for stocks they believe are underrated by the market.
They also believe that the overreaction that follows good or bad news for any company can lead to price movements that are not representative of the company’s long-term fundamentals. Therefore, such situations provide value investors an opportunity to buy stocks and other financial instruments at heavily discounted prices, as these investors avoid following the herd.
Now, before getting into the nitty-gritty of becoming a value investor, let us first discuss the top reasons that make value investing work.
5 Reasons Why Value Investing Work
Value Investing Presents a Wide Margin of Safety
The margin of safety refers to the difference between the intrinsic value of an asset and its purchase price. Savvy investors look at this margin to determine their relative risk. Volatility is one of the primary reasons behind the swings in the margin of safety for any stock.
Value investors don’t panic in the face of volatility, as it usually translates to large income opportunities. They either get in on stocks that have huge potentials but have been too costly for their risk appetite in the past or double down on existing investments at even better prices.
Value Investors Experience a Higher Chance of Success
Value investors often buy into an investment when it is cheaper, which reduces the chances of losses, as the intrinsic value of any asset will keep it from falling a lot lower. Therefore, many value investments go into profit quickly and tend to stay there indefinitely. The general crowd buys into investments at their peak (or tops), increasing the possibility of sitting through a drawdown or reversion to the mean.
Value Investors See a Potential for Very High Returns
Since value investors make their move at a time when the stocks are trading below their intrinsic value, they can hold and sell when the stock reaches or surpasses its actual value.
Undervalued stocks typically have the potential to generate exponential profits over time, assuming the underlying fundamentals were sound originally. A solid value investment pick tends to reward investors that can stay patient through short-term market fluctuations with high returns, which is why value investing is ultimately more rewarding compared to other stock investment strategies.
From a basket of value investment assets, a few of them will post outsized returns, countering the results of poor performers. Even when a bad year hits, the high returns from previous years will provide a cushion, pending when a new high watermark is achieved.
Value Investors Have an Improved Control Over Assets Held
Value investing allows you total control over your investment because you are buying into one asset, which you can drop at any time you deem fit. You can also reallocate or rebalance assets from time to time, adding or removing capital as the case may be, which is not the same in other forms of investing, where investors have to stay tied to an index regardless of the performances of individual companies.
You can’t drop companies you no longer believe in either.
It’s no surprise that a value investment portfolio based on 7-10 assets can post better results than the standard index. This is why some of the biggest names in the trading world recommend value investing to anyone with the right skills to go hands-on with their investment instead of buying into an index fund.
There Is More Belief in a Portfolio
Value investing involves due diligence and gaining deep insights into an underlying asset. An investor that knows the value of a stock will be less likely to get shaken out by market volatility. They don’t stay awake all day looking at prices, charts, or their equity curve. Instead, they stay patient, safe in the knowledge of the workings of the companies that make up their portfolio.
The lack of belief in an asset stems from not knowing the driving forces underneath. Impatience follows, with an investor liquidating their portfolio as soon as a bit of a drawdown occurs.
How Can You Become a Value Investor?
To become a value investor that can choose the perfect investments, here’s what you should do:
Focus on Your Competence Areas
Your competence areas are those sectors of the economy where you have the most knowledge, which could be due to your professional leanings or everyday experience. If you’re experienced in the field of pharmaceuticals or hospitality, you’ll find it easier to unearth opportunities in these sectors compared to, say, aeronautics.
The market is filled with different types of companies. Attempting to wing through all of them will lead to improper due diligence. How can you know what works and what doesn’t if you don’t have a proper understanding of the industry?
Find Investment Ideas
Once you’ve highlighted your competence areas, it is time to find investments. Focus on companies with low stock prices that are well-managed, highly organized, and have a product line you understand well. You can find these companies in various ways:
- Look at the new low lists from the stock market and pay attention to companies around core competence sectors. The lists will contain stocks that have been hitting new lows in stock price over a specific time period.
- Read the publications that track the stock market and pay attention to new entrants within your competence areas. You should also read newsletters from hedge funds and mutual funds as the investment firms often publish their justification from specific investments in them.
- Pay attention to the 13F disclosures of companies with assets valued above $100 million.
- Read reports on companies of interest in major publications, as the information reported (lawsuits, acquisitions, layoffs, etc.) can open the way to a new investment opportunity.
Evaluate Interesting Businesses
When you’ve mapped out a few potential investments, it is time to research them while looking at their revenues, losses, and overall structure. A good metric for evaluating businesses is to check to see if their book value has grown at a high rate based on a per-share basis.
You can also try forecasting the future earnings of a company by paying attention to the total amount of equity a business has added over the past few years and then calculating the return on its investment.
Don’t forget to pay attention to the management structure. Businesses with a stable management structure have a higher chance of success over the long term.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
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Conclusion
Value investing works because it rewards patience and the ability to buy low and avoid moving with the herd. The upside to a single value investment is very high. Therefore, investors don’t have to be right all the time to make money overall and beat almost every index fund you can think of today.
However, the main caveat with this style of investing is that you need to know what you’re doing. You need to have the skills to research businesses behind stocks you’re interested in to determine if the stock is undervalued or not.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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