1. VALUE INVESTING IS A MINDSET
History shows that most people have no idea how to rationally invest in equities. They tend to make investment decisions based on two emotions – fear and greed.
Value investing is a mindset based on the insights of professors Benjamin Graham and David Dodd of Columbia Business School in their breakthrough book SECURITY ANALYSIS (1934) and Graham’s later book THE INTELLIGENT INVESTOR (1949). Their most famous and successful student was Warren Buffett, the chairman and CEO of Berkshire Hathaway. He is considered one of the most successful investors in the world and has a net worth of US$82 billion as of July 18, 2019, making him the third-wealthiest person in the world.
Reduced to its fundamentals, value investing is quite simple. It’s about buying shares of companies that are temporarily undervalued by the market. The theory is that if the business does well, the stock will usually follow.
THE VALUE INVESTING CAFE
Imagine you’re going to buy a cafe.
The current owner tells you she wants $1,000,000 for it.
How do you know if that’s a reasonable price to pay?
You’ll probably look at a number of factors to help you work out how much you think it’s actually worth.
- How much profit does the cafe make each year?
- What kind of assets does the cafe own?
- What does it have in the way of debts?
- How long has it been operating?
- Are its profits consistently going up?
Value Investing asks similar questions of equities.
2. HOW DO YOU FIND UNDERVALUED SHARES?
The discipline of value investing is to only buy shares that you deem to be temporarily undervalued by the market – and then holding them until the market catches up. This is the opposite of what most people do – jumping on the hot stock of the day and hoping it keeps going up. Value investing tries to remove the emotion involved in buying equities and concentrates only on financial data.
The trick, of course, is knowing how to value a share. There are many different ways to do that and no two ways are exactly the same. Most of them involve some process for estimating what the shares should be worth today, based on the performance of the business, comparing that to how the market values it today, and estimating what it will be worth in the future, based on the available data.
We are looking for companies that have a history of strong financial performance (that is, they are consistently profitable) and whose shares are currently trading at a discount (that is, the share price doesn’t reflect the actual value). Surprisingly, very few companies meet both of these metrics at any given time. Our goal is to weed out the ones that don’t and the rest should outperform the market.
3. SLOW AND STEADY WINS THE RACE
History shows that stock markets tend to go up about ten percent per year on average. Some investors are content with that return and will invest in index funds. Other investors, however, will want to try to beat the market. Some will try to make extraordinary returns and will try their luck with high growth stocks. But high returns only come with high risk.
The world’s best investor, Warren Buffett, has achieved a 19.7 percent average annual return over 48 years, and considers himself very low risk – one of his most famous sayings is “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” So 19-20 percent per year seems like a reasonable low risk benchmark to aim for.
Those kinds of returns aren’t going to make someone rich quickly – but they compound over time. For example, $10,000 invested today at 19.5 percent interest will be nearly $60,000 in ten years. Value investors are content to take their low risk 19-20 percent annual growth and let it compound over a long time frame.
4. HOW DO I LEARN VALUE INVESTING?
A good place to start would be to read the books listed here.
The QAV Value Investing checklist is the result of Tony’s study of the world’s best value investors over 25 years. It’s his quick way of assessing the quality and value of companies on the ASX (the Australian Stock Exchange) but the same process works on other exchanges. We know of people using our checklist in the USA, Canada, New Zealand and Switzerland.
If you want to learn how to use it properly, check out the first couple of episodes of our popular Australian investing podcast.