If you have completed our Value Investing Quiz #5, here is the analysis and results. If you have not, please take a few minutes to attempt it here first before reading on. Doing so will allow you to derive greater value from this post.
Question #1. Value Investors are prepared to hold on to their stocks until the Value is realized. They are essentially long term investors.
This is a relatively easy one and 90% of you have gotten this right. Great start, well done!
#2. Successful Value Investors tend to be contrarian in nature, buying when everyone in the market is selling and selling when everyone in the market is buying.
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True again. 84% of the respondents answered this one correctly.
Value Investing is essentially about buying stocks mis-priced by the market. The stock market in the short run is driven by fear, greed and the herd mentality. Putting two and two together, when the market is experiencing a bull run, greed drives investors to pile in and lifts the prices of stocks beyond their fair value.
When the market is experiencing a downturn and fear causes investors to bail out in droves, stocks sell for below their fair value. It is at this point in time, unfettered by what every one in the market is doing, that shrewd value investors come out in full force to pick up bargains. Hence the contrarian label.
#3. Value Investors adopt Qualitative methods in order to select which stocks to buy. A successful Value Investor is proficient with reading annual reports and attends AGMs to understand the nature of companies’ business and the strength of their management team.
A whopping 93% think the answer is true but in actual fact it is a false statement. Gotcha.
You could be thinking: Warren Buffet is a successful value investor. He reads annual reports and understands the nature of companies’ business and the strength of their management team before he decides to invest. Hence the answer must be true. If that is the case, then you only have half the story. Warren Buffet is a successful value investor but not the ONLY successful value investor.
I would like to use this question to introduce you to (if you are not already acquainted with) the late Walter Schloss. A disciple and a former staffer of Benjamin Graham, Schloss ran his own fund from his New York City apartment for over four decades. His compounded returns from 1955 to 2000 was 15.3% versus 10% for the S&P500 over the same period of time. Unlike his more well known counterpart, Schloss stayed true to Graham’s pure style of value investing, buying based on publicly available information, companies with real assets and little or no debt.
The difference between Buffet and Schloss can be summed up as follows. Buffet studies businesses and understands the management team (qualitative). Schloss looks at numbers purely (quantitative). Buffet buys a few stocks that he knows well (focused approach). Schloss owned in excess of 1000 stocks (diversified approach). Buffet wants to own a stock forever, while Schloss sells his whenever they have realized their value. Read more about Schloss here.
Essentially, Value Investing is about finding out how much stocks are worth and then buying them cheap. It does not matter whether a qualitative or quantitative method is used in valuing them. (Read more about the two methods here). You could be just as successful a value investor without any inkling of companies’ business model, their competitive advantage and the unique selling price of their product.
#4. Growth Investing and Value Investing are at opposite ends of the spectrum. It is impossible to invest in growth and value at the same time.
False. It is possible to invest in growth and value together. First let’s look at exactly what growth and value investing are.
Growth Investing is commonly defined as when an Investor seeks out stocks with good growth potential. This potential is often factored into the stock price, and as a result, growth stocks tend to have a higher Price to Earnings (PE) ratio. Take for example Amazon (AMZN). The stock is now trading at $376 and the last reported earnings per share is $0.28, giving it a PE ratio of 1367. In other words it would take 1367 years before an investor recovers his outlay based on earnings. The only reason why investors are willing to pay so much for the stock is because of its growth potential.
The definition of value investing on the other hand is about buying stocks for less than their intrinsic value. One of the most basic and common way to value stocks would be via their earnings. Take Chevron Corp which is now trading at $123 with earnings per share of $12 for a PE of 10. To buy a stock that is able to return my outlay in 10 years definitely sounds like better value than one that takes just over a thousand years to do so.
If your definition of value and growth investing is based on PE ratio I would concur that it is impossible to invest in value and growth simultaneously. However, value investing is much more than earnings. One could also determined the ‘value’ of a company via the amount of assets it owns. A growth stock with good assets and a high Net Asset Value (NAV) and consequently a low Price to Book (PB) Ratio might end up to be a great value investment. Such stocks are hard to come by but it does not mean that they don’t exist!
Buffet famously remarked that Value Investing and Growth Investing are joined at the hips. We are in total agreement.
#5. Value Investors use Intrinsic Value as an indication of how much a company is worth. This amount can be obtained from the Balance Sheet Section of the Annual Report.
False. Only 32% managed to answer this one correctly.
This is a double barreled question. The initial statement is true; value investors are big fans of Intrinsic Values. However, Intrinsic Value is never published in the Annual Reports! It is subjective and determined by individual investors and analysts and different individuals using different valuation methods will come to different conclusions of the intrinsic value of a company.
#6. Value Investors are always on the lookout for a good Margin of Safety. The Discounted Cash Flow method can be used to determine this margin.
True. 86% answered this correctly.
However, be forewarned that the Discounted Cash Flow method is heavily dependent on its assumptions. A small tweak in the parameters used in the forecasting would greatly affect the end results and if an investor chooses to use this method it is crucial to understand and agree with the assumptions involved before submitting to the final valuation and hence margin of safety.
#7. Benjamin Graham was the first to use the net-net method of valuing companies. A net-net is a company selling for less than current assets minus all liabilities.
True. Easy one, 90% answered correctly.
#8. A high Price to Book (P/B) Ratio indicates that the stock is highly valued by investors and hence signals a good buying opportunity.
False. And it is surprising to see more than 20% of respondents answering this one wrongly.
A stock with a high P/B Ratio indicates that the investors are paying multiples of what the stock is actually worth. Stocks with a low P/B Ratio, where investors are paying lesser for a stock than what it is worth, present better buying opportunities from a Value Investing Point of View.
#9. Value Investors tend to own a few stocks that they have in-depth knowledge of. In Value Investing, a focused approach works better than diversification.
False. 80% of you got this one wrong.
Warren Buffet is a fan of the focused approach. He famously remarked that diversification is a compensation for ignorance. As a result everyone jumped onto his focused approach bandwagon without much thought as to what it takes and whether they themselves would ever arrive at Buffet’s level of competence in understanding businesses and valuing stocks.
Again because with Warren Buffet being such a strong advocate of the focused approach, many retail investors are led to believe that a focused approach is the only way to make money. One only has to look at Walter Schloss to see how far from the truth it is.
In short, Value Investors is not synonymous with either approaches. The focused approach and diversified approach both work. What is more important is the Investor adopting the correct approach that fits his or her personality and strengths. Remember, not everyone can be Buffet.
#10. Value Investors use different methods of determining the fair value of a company and deciding what to invest in. There is no single right or wrong method that is superior over others.
Give yourselves a pat on the back for reading so far. Quizzes are demanding for the reader and we do know that it is much more comfortable for you to be reading an article rather than attempting a quiz that requires a lot of thinking. However it is only when we think and challenge ourselves constantly that we learn best and improve.
Also, some of you have commented that the questions are very tough. My intentions in building this quiz (or other quizzes for that matter) is not to score and rank readers. Rather I want to have something in there for everyone, both budding Value Investors new to the game and seasoned veterans. If through this quiz I have managed to expose you to just one new aspect of Value Investing, the quiz would have served its purpose.
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