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Value Investing - The ‘Sharp’ Way to Make Long-Term Profit

written by Mercurius

Attaining financial independence is little more than a dream for a significant proportion of the population. The primary obstacle is the need to ‘invest money to make money.’ If you lack savings, it is tough to make that huge step towards freedom.

However, even those with money in the bank struggle to boost their pension pot by a level that comes close to the rising rate of inflation. As of October 2019, the UK inflation rate was 1.7%. In 2018, the average rate of interest on savings was just 1.18%! In other words, you will find it hard to find a bank savings rate that matches inflation, let alone beat it.

Therefore, those with the means MUST find a way to make their money work for them. Investing in the stock market is a tried and trusted method of doing so. Get it right, and you can have the financial freedom you crave. However, make a mistake or two, and your bank balance suffers horrendously.

Value investing is a strategy that appeals to prospective investors of all ages and salary brackets.

What is Value Investing?

In simple terms, it is the practice of purchasing undervalued stocks. Value investors look for stocks that seem to be available for less than their intrinsic value. In theory, you end up with an asset worth more than what you paid for it. Over time, the value of the asset reaches its ‘true’ level, and you profit handsomely.

In finance, something’s intrinsic value is its “true, inherent, and essential” value. A value investor will see a stock priced at €40 per share. After analysing the company’s fundamentals to understand the underlying figures, the investor could discover that the firm’s intrinsic value means the real value of a share is €65. They invest in the belief that these shares will rise to €65 and beyond.

Value Investing Origins

A pair of professors at Columbia Business School, Benjamin Graham and David Dodd is accredited with the ‘invention’ of value investing in 1928. The duo looked for public companies they believed were trading at discounts to book value or tangible book value. They also focused on firms with high dividend yields and companies with low price-to-book ratios or price-to-earnings multiples.

Here is a brief description of some of these terms:

  • Price-to-Book Ratio:Price-to-Book Ratio: A measurement of a company’s value compared to its share price. If the price is less than the value of the assets, the stock is underpriced, assuming the company is in reasonable financial shape.
  • Price-to-Earnings: Outlines the company’s earnings track record to see if the available share price isn’t accounting for all earnings.
  • Free Cash Flow: The money generated from a firm’s revenue/operations after subtracting expenditures. It is the cash that remains when the company pays expenses such as capital expenditures and operating expenses.

Other salient factors include analysis of sales, revenue growth, debt, and equity. You must also consider an organisation’s business model, target market, brand, and any competitive advantages it has.

Margin of Safety

In 1934, the pair released a book titled: Security Analysis. It was here that Graham outlined his belief in the ‘margin of safety’ when investing. A savvy investor purchases a stock well below its true value according to his analysis. By doing so, you increase the rate of profit if you are right, and reduce losses if you misread the market.

Graham was a staunch proponent of only making a purchase when a stock was no more than two-thirds of its intrinsic value. For example, a stock available at €60 a share would need to be worth €90 before he would invest.

Value Investment Stock Choices

One of the mistakes made by would-be value investors is to risk money on high-risk, high-reward shares. Here are some examples:

  • Small Cap Shares: According to Investopedia, Small Cap Corporations have a value of between $300 million and $2 billion. Such firms have the potential for undervaluation, but volatility is extreme. Also, there are issues with liquidity to consider. We outline the risks of Value Investing a little later on.
  • Junk Bonds: The name makes it seem as if this investment option is a scam akin to a Ponzi Scheme. In reality, Junk Bonds are high-paying bonds with a low credit rating. Once again, they are high-risk, potentially high reward.
  • Start-Up Stock: As you can probably guess, this relates to investing in a brand new company. The risks should be obvious here. For every tech start-up that turns out to be a runaway success, there are multiple failures.

The above forms of value investing run contrary to the teachings of Graham and Dodd, and their famous disciples such as Warren Buffett. The fathers of value investing always advised people to look for solid companies with a decent track record. As Buffett said: “It’s better to buy a great company at a fair price than a fair company at a great price.”

Value Investing - A Counter to Market Efficiency Theory

According to the Efficient Market Hypothesis (EMH), shares always trade at their fair price on the stock exchange. Therefore, it is virtually impossible to find undervalued companies. EMH proponents also suggest that you can only ‘beat the market’ by investing in risky propositions. They say the best way to make money is to play it safe and allow the market to give you a moderate Return On Investment (ROI) in the long-term.

A June 2015 study by Morningstar Inc. compared ‘traditional’ investment options such as Exchange-Traded Funds (ETFs) against ‘active’ fund managers (those looking to beat the market). Only two groups of active managers ‘defeated’ their passive counterparts more than half the time. Moreover, only 25% of active managers defeat passive ones over a long-term period.

Followers of EMH suggest such data proves them right. However, the claim is that it’s impossible to beat the market regularly. The existence of Graham and Dodd, not to mention acolytes such as Buffett, Laurence Tisch, and Martin J. Whitman, suggest otherwise.

We have to acknowledge that there is a bias when discussing well-known value investors. Usually, we only hear about the successful proponents of value investing. There are countless failures but also enough ‘winners’ to suggest that EMH is a flawed theory at best. Here are four reasons why you should not take the Efficient Market Hypothesis as Gospel:

There Has to be a Starting Price

The EMH says that the market reflects the fair price of any stocks quoted. However, there WAS a different price at some point before the publicly quoted price. The existing price is only accurate because a trader captured the difference in prices to provide a ‘fair’ price. That individual either sold or bought the stock. The price moved, so someone made a profit before the price became public.

Flash Crash

The EMH has a weak formulation that allows the occasional crash, such as the chaos of Black Monday in 1987. At present, experts can’t agree on why bubbles form and burst in otherwise stable circumstances. In the aforementioned crash, the Dow Jones Industrial Average fell by over 20% in a single day. Therefore, it IS possible for the market to deviate from its true value.

Laws of Probability

If the ‘chance’ of beating the market in a single year is 50%, doing so consistently becomes hard work if relying on luck. The best value investors beat the market for 25+ consecutive years. The odds of doing so through ‘luck’ are slightly greater than 33 million to one!

Also, Graham and Dodd’s principles have worked for over 90 years! There is a group of well-known investors who beat the Standard & Poor 500 Index consistently over a long period. This is proof that it IS possible to beat the market.

Human Traits

The rise and fall of the stock market are primarily based on human reactions to the news. There are LOTS of inefficient investors who latch on to rising stocks or sell off falling stocks in a panic when the price drops slightly. Value investors seek out undervalued stocks, and, if the underlying financials are good, back the price to recover over time.

In betting, the bookmaker sets a price, but it mainly rises and falls depending on how much money is placed on an outcome. If a lot of people back a favourite at odds of 1.80, for example, the bookie must drop the price to cover its liabilities in case the favourite wins.

The Risks of Value Investing

There is an element of risk to every form of investment, and value stocks are no different. The first thing to remember is that you are relying on your reading of the company and the market. If you dive in without performing due diligence, you won’t like the outcome! Here are a few of the risks:

Lack of Liquidity

We love the Betfair Exchange because of the high level of liquidity. It is relatively easy to ‘back’ and ‘lay.’ Rule 101 in investing: A stock is worth what someone is willing to pay for it.

Let’s say you find a value stock at €32 per share, and your analysis concludes that the intrinsic value of the company means the price is €50 a share. The price rises to €52, and you feel very smug. However, when you try to sell, no one wants to buy at €52, or €48, or even €44! Now, you are stuck with a stock you can’t sell!

Small cap investors, in particular, could find it hard to offload shares.

Volatility

If you invest in ‘value’ shares in a volatile market, the price of your investment will rise and fall at extreme speed. You may find a company whose share price has tanked. You believe now is the time to buy, but to your horror, you learn that the market’s volatility causes the price to crash even further. In some cases, the price never recovers.

In a volatile market, you have little time to react if things go badly; and they can go wrong in a hurry! That is why Graham and Dodd always preached the importance of finding solid companies in a stable industry. An undervalued ‘Blue Chip’ firm is usually a better investment than a ‘hot’ start-up, for example.

Currency Risk

Foreign diversification has a lot of benefits, but a few downsides as well. If you live in the Eurozone and trade in U.S. Dollars, for example, you have to worry about currency rates hurting your investment, as well as the market in general! Let’s say your foreign holdings (in Dollars) had a profit of 11% but the Dollar lost 10% against the Euro in the same year. Your net returns are miniscule in that scenario.

Macroeconomics Changes

You have to consider factors such as law and regulation, tax reforms, and other global changes. If the overall performance of the financial markets hits a downturn, there could be dire consequences for companies, which hurts their value. Imagine investing in a marijuana company in California only to find out that the state has decided to rescind previous legislation allowing legalisation!

Value Investing - How to do it Right

Risk managementis essential. Here are a few tips.is essential. Here are a few tips.

Diversification

Do NOT focus on a single sector, asset class, stock, or country. When you diversify, you spread the risk. If you have six different investments, for instance, you can have two that perform poorly but still come out on top if the others remain solid. Also, divide your portfolio into low, medium, and high risk depending on your appetite for risk.

Embrace Modern Portfolio Theory

MPT assumes that investors are risk-averse. This means it focuses on people who want to make money at a realistic rate with relatively low risk. The idea behind modern portfolio theory is to create a portfolio that maximises expected return based on a set level of market risk.

In theory, you can construct an optimal portfolio of investments that provides the highest return on investment for the associated level of risk. Using MPT, you can ‘weight’ you investment accordingly depending on the expected level of return, It gets a lot more complex as you must calculate the variances and correlation assets of each asset, but it is worth looking into.

Avoid the Value Trap

This refers to a stock that appears undervalued because of its low cash flow, book value, or other valuation metrics for a long period. Investors risk money in the belief that the stock will soon rise, only to find that it falls even further. What the figures may show, if you look deeply enough, is that the company is not innovating, can’t contain certain costs, or else it has made no changes to its competitive stance.

Buy the Business, Not the Stock

Forget market noise and focus on the brand. Check out the company’s fundamentals to ensure it has adequate growth potential. While it is essential to check data such as price-to-earnings and price-to-book, you also need to be passionate about what the company is and what it represents.

Ignore the Market Most of the Time

The only two times the market matters are when you buy and when you sell. Ignore it at all other times once you have decided that the investment is a sound one. While there are times when you can sell for a good profit, a value investor should be as slow to sell as they are to buy. As long as the company’s fundamentals remain strong, it is worth staying with for the long-term.

Value Investing - Conclusion

Those who go forth and take on the markets by trying value investing must ignore their emotions, and only pay close attention to the market when it is time to buy or sell. One real-world example of a value investment occurred in 2016. In May of that year, FitBit released a Q1 earnings report. Its share price fell by 19% in a very short space of time.

However, the company earned huge revenues and announced even better future returns. What happened was that FitBit invested heavily in Research and Development, which skewed its figures and caused a fall in earnings per share compared to the previous year. Casual investors sold their stock and caused the price to fall way below its true value.

There are a myriad of similarities between value investing and value betting. Both look to find ‘value’ in a market. To succeed in either sphere, you must conduct a thorough analysis in an unemotional fashion. In the long-term, you CAN beat the market in both cases.

At Mercurius, our technology analyses millions of data points to discover when a betting outcome is overpriced. Interested in learning more? Get in contact with our team.

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