In stock markets, just as in any other field of life, they also serve who just stand and watch on the sidelines for the right opportunity.
Whenever bulls running amok stumble, hordes of waiting value investors rush in for bottom-fishing. Imagine what it would have been like without someone waiting, thinking and jumping to pick up the falling pieces. Without such support, the stock market sometimes might as well go on a long vacation. But remaining a committed value investor when everybody else is raking quick profits is not an easy job. It requires lots of patience, self-control and a good sense of market humour.
Johnny: I am sure there must be several other qualities of a value investor. But leave that aside for the time being and tell me, what is a value investment?
Jinny: What we call value investment is a well-known investment strategy. Some of its followers such as Warren Buffet, Peter Lynch and many others have consistently performed better than the average market. It’s no surprise that value investment almost enjoys a cult-like status. Just when the bullish market thinks that value investment is dead, it comes right back with new vigour.
The initial groundwork in the area of value investment was done by two finance professors at Columbia University, Benjamin Graham and David Dodd, in their pioneering work Security Analysis published in 1934. Later on, Graham wrote a book, The Intelligent Investor, in 1949, which is to this day a must-read for anybody interested in the stock market and which is like a bible of value investment. The basic premise of value investment can just be stated in one sentence: Buy a stock only when the market price of a stock is lower than its intrinsic worth. The whole strategy of value investment lies in finding out a stock with a higher intrinsic worth.
Illustration: Jayachandran / Mint
Johnny: So that’s the first rule. Value investors should always focus on intrinsic worth. But how do you know about a stock’s intrinsic worth?
Jinny: Now we move over to the real challenge—how to find out a firm’s intrinsic value.
There is no quick formula which can tell you a firm’s intrinsic worth in a moment. Value investors use fundamental analysis by looking at financial statements and key ratios of a firm to know its true worth. One approach of estimating intrinsic worth could be to look at the book value of a firm’s assets such as its plants and machinery, cash in its bank account, inventories lying in its warehouses, and so on. Sometimes the book value of a share might be higher than its market price.
Value investors always look for lower price-to-book ratio. However, that’s not the only way of choosing the right candidate. You can also estimate the intrinsic worth of a firm as the value of all future income it may be capable of generating by using all its tangible and intangible assets. Value investors look for an opportunity when the current market price of a share looks cheaper compared with the future earnings per share. To make the comparison meaningful, value investors always examine the price-to-earnings multiple. The biggest problem is that there is no “correct” intrinsic value.
Two investors using the same information can arrive at two different intrinsic values. That’s why value investors make use of what is called “margin of safety” in any investment. “Margin of safety” implies that you buy stocks only when the price is sufficiently low to cover any error in computing the intrinsic value. In that way, your investments remain safe. So to become a successful value investor, you should know how to apply the “margin of safety”.
Johnny: Yes, we know that fundamentals never lie but it’s always better to keep a margin of safety. But why would a stock ever trade at a price lower than its intrinsic worth?
Jinny: Well, sometimes the average market fails to take a balanced view. It fails to correctly read the fundamentals. As I said, there is no “correct” intrinsic worth just as there is no “correct” market price of a stock. It all depends upon perceptions. Mostly, the market thinks in the right direction just like an efficient machine using all available information. But sometimes it overreacts.
Just one quarter of negative earnings or some other bad news about a firm or industry and the stock price could fall like a dead bird. That goes against the basic tenets of the efficient market hypothesis, which believes that market prices correctly reflect the true picture. The existence of value investors proves that sometimes the crowds miss the wood for the trees. Value investors succeed because they always look at the big picture. They believe that not everything hit by random market events dies. Patience, after all, has its own value.
Johnny: That’s true. Those who have patience reap their rewards not only in this world but also in the other world.
What: Value investment is an investment strategy in which an investor invests in undervalued stocks.
How: For locating an undervalued stock, the current market price of the stock is compared with its intrinsic worth.
Who: The idea of value investment was developed by Benjamin Graham and David Dodd.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org