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What is Value Investing – Advantages & Strategies of Value Investing

The idea behind value investing is to purchase assets at a discount to their intrinsic value. Let’s dive deeper into understanding the whole concept of Value Investing.

Various investment strategies

Investors follow various investment strategies. Some of these include value investing, in which the stock trades at a lower value than its intrinsic value. Some investors follow the growth investing strategy, which involves investing in companies that are in a high growth phase. Some investors follow the momentum investing strategy that involves investing in stocks that are riding the momentum wave. This blog will focus on value investing, its advantages, and its strategies.

What is value investing?

Value investing is the process of investing in stocks that are trading at a discount to their intrinsic value. It means identifying stocks that are undervalued. Such stocks offer a margin of safety that can be determined by doing a fundamental analysis of the company. Once the market identifies them and starts giving them the actual valuation they deserve, they give healthy profits to investors who bought them earlier when they were undervalued.

Benjamin Graham introduced the concept of value investing. He is also known as the father of value investing and has spoken about it in the book "The Intelligent Investor". Warren Buffet learnt about value investing from Benjamin Graham and has followed it throughout his investment journey. It has made him one of the world's richest persons.

How does value investing work?

The process of value investing works by identifying companies for investment when they are trading at a discount to their intrinsic value. The best time to identify such companies is on two occasions: when the individual company is facing some challenge or when the overall market is down. Let us talk about both these scenarios:

  1. Individual company challenges
    • When a good company is undergoing challenges, the stock price is down. For example, FMCG companies may face headwinds when inflation is high, and they cannot pass on higher input costs to customers. Financial companies may underperform during a high-interest rate scenario. A pharma company facing audit issues with the US drug regulator may underperform in the short term. Hospitality and entertainment stocks underperformed during the Covid-19 pandemic as there was a restriction on people's movement.
    • In all the above instances, the shares of the individual company or companies belonging to a particular sector may be trading at a deep discount to their intrinsic value. A value investor can buy such companies and hold them. With time, the individual company or sector overcomes the headwind/s, and the market rewards it with a higher valuation. It leads to good profits for value investors who bought the companies when the share price was down.
  2. The overall market is down
    • Whenever there is uncertainty over an event such as a pandemic, war, elections, etc., it usually takes the entire market down. In the process, many good companies with high market share, high margins, regular dividends, and high growth outlook are available at prices lower than their intrinsic value.
    • A value investor can buy such companies at bargain prices when the entire market is down. Over time, the market overcomes the uncertain event and recovers. During the market recovery, good companies are the first to recover; as a result, value investors who bought the shares at low prices get rewarded.

How do investors derive intrinsic value?

Various investors derive intrinsic value using various methods. Let us take Warren Buffet's example to understand how he derived intrinsic value.

  1. Invest in businesses that you understand
    • Warren Buffet says that you should identify your circle of competence. First, you should identify the sectors that you understand. As a next step, you should focus on the companies that you understand within the sector of your competence. At the same time, you should maintain a distance from sectors and companies you don’t understand.
  2. Invest in businesses that have a strong economic moat
    • You should look at companies that have a competitive advantage. The competitive advantage can be in the form of monopoly or highest market share, pricing power, high margins, etc. Let us look at some examples. In the railway ticket booking space, IRCTC has a monopoly. In the depository space, CDSL is the only listed company. Among stock exchanges, BSE and MCX are the only listed companies, with BSE focused on equity trading and MCX focused on commodity trading. In the power transmission space, Powergrid has the highest market share.
  3. The management must be trustworthy
    • The management is the one that takes all the decisions related to the company. So, as a value investor, you need to analyse whether the company management follows the best corporate governance practices, is consistent in creating wealth for shareholders, rewards shareholders regularly, etc. 
    • For example, companies such as Infosys, HDFC group companies, Tata group companies, etc., trade at a significant premium compared to other companies in the same sector. It is because the management of these companies follows the best corporate governance standards and takes decisions in the interests of shareholders.
  4. Identify companies that are trading at a discount
    • As a first step towards value investing, you need to shortlist the companies you understand. As a next step, among these companies, you need to identify those with an economic moat and where the management is trustworthy. Finally, you need to calculate the intrinsic value and compare it with the market share price. If the market share price is lower than or near the intrinsic value, you may go ahead and buy the company shares. If the market price is significantly higher than the share price, you may wait for a price correction.

Advantages and disadvantages of value investing

The biggest advantage of value investing is that you get to invest in good companies at bargain prices. Once you invest in a value company, there is a margin of safety. Over time, the market will recognise the company and re-rate it. Once the re-rating happens, the market share price will go up, and the value investors will get rewarded.

However, sometimes the value investors may have to wait a long time for the market to recognise the company is undervalued. So, the long wait time for the company share price to appreciate can be one of the disadvantages of value investing. In the case of some companies, the value theme may not play out as expected, and the share price may not appreciate as expected. Such companies may turn out to be value traps.

Strategies for value investing

You may consider various strategies for value investing, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, discounted cash flows (DCF), etc. The P/B ratio may be used for valuing financial companies. The P/E ratio may be used for valuing companies that are making profits. The DCF method may be used for companies that are not making a profit. Whichever method you use, you may compare the intrinsic value with the market share price and accordingly take an investment decision.

Identifying stocks for value investing may mostly work when a good company or a sector is going through a bad patch or when the overall market is going through a price correction due to some event. In bull markets, it is difficult for value investors to find good companies for investing at bargain prices.
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