Forget price, value investors are concerned with the ‘intrinsic’ or ‘underlying’ value of a stock. But what does this mean? How can you join the ranks of Buffett and other legendary value investors, to make returns in excess of 20%?
What is value investing?
It’s important to understand stock prices fluctuate and reflect the demand and supply of the stock by investors at a particular time, rather than how well the company has been performing.
Value investing is a philosophy that prizes the underlying value of a company rather than the price of a stock. With this in mind, value investors look for stocks whose market price is less than the underlying value of the company.
The value investing gurus
Although Warren Buffett is the first name which comes to mind when it comes to celebrity investors, let’s look at some others who may not receive as much limelight.
Benjamin Graham is considered to be the founding father of value investing. The American academic believed you should not follow the herd mentality of other investors, but rather make your decisions independently. He also argued that buying cheap stocks protects you from a drop in the share price, which Graham described as the “margin of safety”.
Buffett was a student of Graham, but the student developed his own value investing principles. Buffett liked businesses that had some type of competitive advantage, such as a strong recognisable brand (think Coca Cola) or low operating costs. Buffett also believed investors need to find out how the company operates and where its profits are coming from. Finally, Buffett realised that a high price may be acceptable if a company is superbly run.
In his 15-point philosophy to investing, Philip Fisher argues a solid company must have open, positive relations with its investors (even during tough times), be run by a highly-qualified management team and have strategies in place that raise profit in the long-term. He favoured companies that had strong prospects for growth.
So how do you measure underlying performance?
It’s all well and good to hear about the classic principles bestowed by renowned value investors, but how can you apply it to your own investing decisions? The concept of underlying value sounds mysterious, but there are some indicators that can help you choose a valuable stock.
The price/earnings ratio (P/E ratio) is a key tool for comparing the underlying value of companies within the same industry. The P/E ratio is the share price divided by the company’s earnings per share (EPS), so it reveals how much investors are willing to pay for each dollar of earnings produced by the company. The EPS can be found in a company’s latest annual report, so the P/E ratio is fairly easy to calculate.
Value investors are on the look-out for relatively low P/E ratios, as they indicate a cheap stock that’s undervalued in the market. However, low P/E ratios could also signal that the share price is low because of a serious issue facing the company.
The debt-to-equity ratio is also an important indicator, which reveals how the company is financing itself. A large figure can cause concern, as it implies the company has taken large loans or issued plenty of bonds.
Free cash flow identifies how much cash a company has on hand, once their spending on items like equipment has been accounted for. Positive free cash flow is ideal for value investors, as it implies the company has funds to pay dividends or expand their growth.
Successful value investors don’t come without certain personal characteristics. So what do you need to have?
Patience and self-discipline are key; it’s important not to get too caught up in the short-term movements in the price, daily headlines and market sentiment.
If it sounds like other investors are panicked, selling off their shares and driving down the stock price, it could be a great buying opportunity for value investors. As Graham argued, be alert but don’t move with the rest of the herd.
The ability to thoroughly research a company is also important, which could be time-consuming. You’ll need to sift through past annual reports, to discover trends in in the abovementioned indicators.
One stock with value
YMM spoke with Alex Hughes, investment analyst at Clime Investment Management, to find out which stock would be a value investor's friend. Hughes says Woolworths (WOW) is a great buy for investors at the moment. The company's focus on food and consumer staples means there will always be demand for the company's products - even during tough economic conditions.
"The market is too focused on the short-term when it comes to the price of Woolworths shares. The company's management, however, is focused on the long-term," says Hughes.
Hughes says Woolworths' new retail hardware store, Masters, will produce a loss for the company over the next couple of years, but is likely to become profitable in the longter-term.
-- By Stephanie Hanna