Value investing can help you get great returns on your investments in the long run. But what is value investing? Read on to find out.
You and your neighbour have bought a new refrigerator. Both of you say, “My refrigerator is a better value buy than yours”. This is because you both have different definitions of value. Maybe you call your refrigerator a good deal because you got it on sale at a good 15% discount. Your neighbour, meanwhile, says her refrigerator is a value buy because it has all the latest features when compared to another brand, for the same price.
Similarly, investors who follow ‘value’ investing have different reasons why they think a stock is a ‘value’ buy. Value investing involves picking stocks that trade at a price that is lower than their intrinsic value. Essentially, you are picking stocks that are undervalued. But there are other definitions for value investing too. It will be easier to learn about them by following value investors.
Who are the best value investors? Won’t you agree that Mutual Fund managers who handle dozens of stocks every day are some of the best investors you could emulate? Several fund managers follow the value investing style for managing their funds and each of them has their own definition of value. Even though all ‘value’ fund managers will buy stocks that they feel are worth much more than the current price, they will not agree on what is ‘good’ value. How will these definitions differ? Let’s find out.
Let us take a simple example of two fund managers, Mr. A and Mr. B. These are two fund managers who manage two of the best equity diversified funds. Both the funds are large-cap funds that invest in big, blue-chip companies and their managers follow value investing. But in the past year, Mr. A’s fund has outperformed Mr. B’s fund. Why is that so? This is mainly because of the difference in their definitions of value. Mr. A followed a strategy where he picked stocks having strong fundamentals but were trading at a big discount to their intrinsic value. According to Mr. A, this is value investing. But Mr. B also followed value investing. According to him, it is picking stocks that are trading lower than their peers. This he did after thorough research. This is also a form of value investing. As is obvious, both the Mutual Fund managers seem to follow value investing but their definitions of value are pretty diverse. So there is hardly any similarity in the way they pick stocks. That is the reason why their funds’ performance is also different. Want to know more about the different types of value investing? Read on.
Additional Reading: How to Invest in Mutual Funds
Styles of value investing
The relative value investing method is where fund managers compare a stock’s price ratios to some benchmark. These include ratios such as price-to-earnings ratio, price-to-book value ratio and price-to-sales ratio. So, here the value is relative to a standard or benchmark. If a stock is trading at a lower value when compared to an index, it can be considered to be undervalued. In this case, the benchmark can include any of the following:
- The Stock’s Historical Price Ratios – If a stock’s price is trading at a price that is lower than its historical price ratio, then you could consider it to be undervalued. Often, these prices of these stocks are lower due to some type of ‘bad news’ or ‘negative vibes’ floating in the market. For example, the stocks of Reliance Industries fell heavily in 2005-2006 when the Ambani brothers had a tiff. Many fund managers saw that as an opportunity to enter the stock.
- The Industry or Sub-sector – When a stock is trading at a price that is much lower than other stocks in the same industry, then it could be undervalued. It is important to ensure that the fundamentals of the company are strong, just as its competitors, which are trading at a higher price. For example, Mindtree Consulting fell to Rs. 86 in 2011. Some fund managers thought that the company was under-priced when compared to its peers. So, several Mutual Funds purchased the stock. Today the stock is trading at over Rs. 500.
- The Market – The most popular benchmark used by value investors is the market or the broad market index. A company with strong fundamentals may be pushed down because the industry in which it is functioning is going through a bad phase. This situation is common in the case of cyclical industries, such as technology or consumer durables. Infosys, for instance, is one of the dominant IT companies, but when its industry is rejected by the market, it will be dragged down, too. Value managers will jump at this opportunity. For example, some years ago, IT company stocks fell heavily due to rupee appreciation and the fear that it would affect the margins of the IT companies. Fund managers saw this as a buying opportunity.
Absolute value investing is where investors don’t compare a stock’s price to any benchmark. Rather, they will try to analyse and find the company’s worth in absolute terms. They will buy the stock if it is trading at any price that is less than this absolute value. Absolute value investors try to find a company’s value using a variety of factors, such as the company’s assets, the strength of its balance sheet, and growth prospects, as opposed to competitors. They will also analyse if private buyers, such as other firms, have invested in the stock.
Additional Reading: Your First Steps To Investing In The Stock Market
Will you ever sell a ‘value’ stock?
There are three reasons why you could choose to sell a value stock.
- First is that the stock stops being a value buy anymore. Stocks stop being good value buys when their prices go back to being fairly valued. This means that the stock is not ‘cheap’ or undervalued using the same measures you used to value it when you bought it. Most probably, the stock has come back to levels that are in line with its peers. For an absolute value investor, the stock would have reached the price it is worth.
- You realise that you didn’t do proper research and made a bad stock pick.
- You may also sell the stock because it looks less promising than it did when you purchased it. It may be due to some adverse developments in the company or the industry.
Value investing has been a popular strategy, thanks to Benjamin Graham and Warren Buffet! Benjamin Graham introduced the concept in the 1930s. Value investing has changed drastically since then but the concept is still in vogue. Do consider value investing when you pick stocks. Not savvy with stock picking? Then invest in Mutual Funds and leave it all to the fund managers.