Introduction to Value Investing – Part 1
In this week’s update, we want to give you an introduction to value investing.
Investing in a particular stock is equivalent to buying an ownership stake in a business. This means that the investor participates in the potential upside and downside of the business. Therefore, this is not a decision that is to be taken lightly. At a high level, there are several approaches on how to select what to invest in: value investing, technical analysis and several others.
What is value investing?
Fun Fact: At the age of 89 years old, Buffett’s daily diet still comprised of ~5 cans of Diet Coke and a healthy dose of fast food & ice cream.
Published in 1969, Ben Graham’s Intelligent Investor is often considered to be the bible of investing. It was the first book to introduce value investing to the world. Since then, value investing has been credited with catapulting Warren Buffett from a shy boy living in Omaha to being the world’s 3rd richest with a net worth of $80 billion.
The core tenet of value investing is that the investor: (1) purchases a stock that is trading at a price lower than its intrinsic value and (2) holds the investment for the long term.
- Purchases a stock that is trading at a share price that is lower than the intrinsic value. Price of the share is what you pay when you invest in a stock, and value is what the stock is actually worth. They are not always the same. Value of the company is dependent on the business, while the share price is driven by supply and demand in the stock market. Sometimes, overhyped (or poor) market sentiment or positive (or negative) news surrounding a company, among many other things, can affect the supply/demand dynamics and therefore affect the stock price, without changing the intrinsic value of the company. For example, Facebook’s share price was hammered for the better part of 2018, even though the business fundamentals were still strong. In another example, negative investor sentiments and market panic in the 2008 recession drove prices down, creating buying opportunities for investors (as Warren Buffet astutely did in the mid of the 2008 recession). Value investors search for these stocks, and invest in the companies that they consider to be trading at a discount.
- Hold investments for the long term. Often times, it can take years for a value stock to fulfill its potential and gain market recognition. Thus, employing value investing strategy means investing for the long term. As Warren Buffett once said: “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.”
Now that you know the two core tenets of value investing, how does an investor execute this correctly?
Value investors typically use a bottom up approach. They give importance only to the intrinsic factors of the business, while all the economic background noise, such as the state of the economy or market sentiment are put on mute. These intrinsic factors can be either qualitative or quantitative.
Qualitative factors could include:
- Business model. Different business models can have profound impact on the quality of the business. For example, a business model that generates revenue on a transactional basis will be more uncertain and generate less cash flow than a subscription based business. This is because transaction based businesses have to spend resources and money on advertising to acquire each transaction, leading to higher revenue variability. An example of a company that underwent this transition is Adobe – its business was transformed after it abandoned a transactional model (selling software by the disc) for a subscription model.
- Management. Warren Buffett has time and again focused on the quality of management of a business. The management team should be rational. This means that the team should reinvest the earnings into the business whenever it’s necessary. It should display integrity with honest disclosure of any mistakes it has committed in the past and should be able to resist the institutional imperative – the tendency to mindlessly imitate a trend or behavior of the competition.
- Brand strength. Apple has one of the strongest brand power in the world today. Despite having only ~10% of the global smartphone market share, the company rakes in almost 90% of all the profits generated from the smartphone industry. The strong brand creates loyalty and becomes a competitive advantage over other smartphone makers; this in turn enables Apple to charge premium pricing. Because of this, and other reasons, Warren Buffett, despite his aversion to technology stocks, has significant stake in Apple (to the tune of US $40 billion dollars).
- Market power. Value investor tends to invest in companies with dominant market share, which can lead to pricing power. For example: Facebook and Google are duopoly in the digital advertising space, with both claiming almost 60% of all digital ad spend in the US.
These are metrics that investors use to determine if a stock is undervalued. Keep in mind that any fundamental analysis done on the basis of metrics should be done by comparing companies within a similar industry/sector. Equally as important, the investor must understand where the numbers come from. These are the core metrics that investors typically look at:P/B Ratio: share price divided by the book value per share tells you how much the market is willing to pay for each dollar of a company’s assets. When the ratio is one or less, the stock is said to be undervalued. Book value of a company is the total value of the company’s assets, minus the company’s outstanding liabilities. These figures can be found in a company’s balance sheet. Using book value as a metric is useful because there is standardization around how to calculate the numbers and therefore limited subjectivity is involved. However, using book value to accurately value intangible assets such as intellectual property or brand value remains tricky.
P/E Ratio: The price to earnings ratio indicates how much the market is willing to pay for each dollar of earnings based on the company’s earnings. This ratio is calculated by dividing the share price to the earnings per share (net income per share). Undervalued stock should ideally be in the bottom 30% of the companies in a particular sector.
PEG Ratio: P/E ratio divided by the expected growth in earnings over a certain time period gives the PEG ratio. The PEG ratio tells you whether a stock’s price is overvalued or undervalued by analyzing both today’s earnings and the expected growth rate. A ratio of < 1 may suggest that the stock is undervalued.
Free Cash Flow (FCF): Cash is king. Arguably the most important metric. Free Cash Flow tells you how much cash the company has after financing its debt and paying for its operating and capital expenses. Free cash can be used to pay off debt, to be distributed as dividends, to conduct share buybacks (which reduces the number of shares issued and therefore increases share price), or to weather poor economic conditions. Growing FCF indicates good health of the business.
Debt to Equity Ratio: The total debt over total equity helps determine how much debt the company has raised to finance its assets/operations. You can find these figures in a company’s balance sheet, which is reported quarterly. A high ratio means that the company depends more on its debt (cash from borrowing) than equity (cash from issuing stocks) to finance its assets and fund its operations. A company with high debt to equity ratio, relative to its peers, can be a riskier investment, as it may be more vulnerable to adverse macroeconomic conditions than its peers. When a recession hits, and revenue slows down, a company with high debt may not be able to pay its debt obligations and may be forced to sell off its assets, conduct layoffs, or go into bankruptcy. Not all debt is bad, however, it is important to analyze what the debt is being used for before making a final determination. Netflix is a company that has been in the spotlight for raising a very high amount of debt to fund content production, which is not necessarily a bad thing. We took a deep dive here and here.
Thanks for reading! Part II will be coming out next week. In part II, we will be dissecting the performance of Value Investing over the past decade.