Value Investing: The Extensive Guide [Edition: 2018]
For Value Investors Who Want To Navigate Today's Markets Successfully and Profitably
Only principle in Value Investing is; "Buy Low, Sell High".
But yea right...its easier said than done!
While the investing superstars (ie Warren Buffett) make millions with it, we are left struggling to make it work for us.
This guide was created for you, the individual investor who wants to grow your wealth through investing.
It'll help you crack the puzzle of "Buy High, Sell Low".
If you don't have the time to read everything now, just click the link below to download this entire guide immediately. It's yours:
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Or, continue for a complete introduction to Value Investing from 5 practical Value Investing Strategies to common terms that you should know as a Value Investor and much more.
This guide is a compilation of the knowledge and wisdom from various iconic and successful value investors.
Enough small talk, let's get started!
First up, a quick glance of the exciting information to come in this extensive Value Investing Guide:
To protect ourselves, and our readers...you! All information in this guide is compiled for educational purposes. They do NOT constitute to finance advance.
What is Value Investing?
Definition of Value Investing:
Value Investing is an investment strategy where investors aim to invest in stocks that are deemed to be "undervalued" (aka under-priced) by the market.
Value investors have to master 2 skills in order to generate profits in the stock market
#1 - Stock Analysis & Valuation
Through stock analysis and valuation, value investors will investigate and determine the intrinsic or true value of a stock.
#2 - Buy Low, Sell High
Using the value derived from Skill #1, value investors will be able to:
- BUY in a stock when its price is BELOW its intrinsic value
- SELL when its price is ABOVE its intrinsic value.
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Value Investing: The Genesis
The concept of value investing has been accorded as the brainchild of Graham and Dodd. Since then, many value investing methods have been created and tested by investors around the world.
In this short segment, we'll take a look at the genesis and evolution of Value Investing. This will help us to understand why Value Investing works, and leads into the next section that takes a swing at the biggest myth in Value Investing today.
The Birth of Value Investing
Value Investing was coined in the 1920s by Benjamin Graham and David Dodd and explored in their book, Security Analysis. You can read the entire history of Value Investing here.
It was revolutionary when proposed by Graham and Dodd as investors in the 1920s were selecting stocks mostly by speculation. Graham and Dodd provided methods to research the value of a company. Graham also shares his investing strategies in his subsequent book, The Intelligent Investor.
Over the years, value investing had been learnt, practiced and modified by many distinguished investors such as Warren Buffett.
The Popularisation of Value Investing
Warren Buffett is largely known as one of the richest men who had made his fortunes from investing. (Interesting facts: The moment when Warren Buffett Became Famous and Warren Buffett’s Journey to Riches)
Because of his reputation, many investors have taken an interest in Value Investing. And because of this increase interest in Value Investing, many have written best-selling books on Warren Buffett and his investing philosophy.
However, it is interesting to note that most of these books were not endorsed nor written by Warren Buffett himself. Despite having this much information around, no one is sure of the exact strategy that Warren Buffett uses.
What we can be sure of is that he has modified his investing strategies from his days under Benjamin Graham. And he admits this directly as he shares about his experience in the 2014 Berkshire Hathaway Shareholders letters:
from 2014 Berkshire Hathaway Shareholders Letters
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.
But a major weakness in this approach gradually became apparent:
Cigar-butt investing was scalable only to a point. With large sums, it would never work well.
Why You Should Not Be Trying To Invest Like Warren Buffett
Warren Buffett has NEVER encouraged investors to invest like him. Neither has he written any official book about investing. The only literature he has written are the shareholders letters that Berkshire Hathaway publishes annually.
This is our warning to all who are still trying to invest like Warren Buffett.
As Warren Buffett’s capital grew, he realised that he had to modify his investing strategy to suit his capital size. Around the same time, he got to know Charlie Munger, his current partner at Berkshire Hathaway.
Charlie Munger is a smart investor who studies the market. Under his influence, Warren Buffett’s investing strategy shifted towards that of Philip Fisher’s.
You can watch this video where Alvin explains the story of Value Investing:
Who is Philip Fisher?
The author of another famous investment book, “Common Stocks and Uncommon Profits”, Fisher is an influential investor of his time.
Unlike Benjamin Graham who looks for a stocks that are highly discounted on the stock market, Fisher would invest in stocks which he thinks are going to be way more valuable in the future.
Here’s a simple example.
Imagine if you could invest in a big company like Facebook before it was well known.
If you were following Benjamin Graham’s investing philosophy, you would not invest in Facebook because its assets are not ‘valuable’ in your eyes.
If you were following Philip Fisher’s investing philosophy, you may see that it has a potential to grow in the future as more people are open to using digital technology to connect, and the advertising revenue has been growing. Hence, you would likely invest in Facebook.
That being said, you will be taking a huge risk because if Facebook didn’t perform up to expectation, you would lose part of your investment capital.
Instead of looking at growth stocks and projecting their value into the future, Benjamin Graham looks at stocks that are already trading cheaper than the value today.
Warren Buffett’s advice to the small value investors
Don’t lose hope yet.
Because Warren Buffett did share how he would invest if he were a retail investor like us. He shared this key information in a Berkshire Hathaway shareholder meeting. You can watch the video here.
Alvin had decoded Warren Buffett’s reply in this article: “How Would Warren Buffett Invest If He Were You” or watch the video explanation by Alvin here: “How Would Warren Buffett Invest With Less Money”
These are the 3 key points that Alvin had picked up:
#1) Buffett would pick Graham type stocks:
“If I were working with small sum, I certainly would be much more inclined to look among, what you might call the classic Graham stocks."
Buffett acknowledged that he would be more likely to invest in Benjamin Graham’s stock picking principles. These stocks tend to be small companies, in unsexy businesses and may even have problems attached. This is a far cry from the big, glamorous companies with competitive advantage which Buffett was known for investing in.
#2) Buffett would have more advantage:
(as a small investor)
“I would be doing far better percentage wise if I am working with small sums, there are just way too many opportunities.”
The reason to use Graham’s approach was because Buffett would be able to get a higher percentage gains, than he would if he stuck with the big companies he usually invest in. There are a lot more small companies he could buy and make money. But he cannot efficiently invest in small companies when his capital became much larger.
#3) Buffett would diversify across many stocks:
“I bought a large number of stocks in small amounts, in companies whose names I couldn’t pronounce. But the stocks as a group were so cheap, you have to make money out of it, it was Graham’s kind of stocks.”
Graham’s principle was to invest small amounts in many companies. It doesn’t matter what businesses they are in as you do not need to do in depth research. In Buffett’s words, he didn’t even know how to pronounce the names, lest to say what the companies do. Due to the large number of stocks, it no longer matters if a few of these companies eventually go bust, but there will be some winners that would more than cover the losses. As a group, or as a portfolio of stocks, it would be an overall gain for the Graham investor.
Since Graham and Fisher, there have been various other forms of Value Investing Strategies and philosophy. We will look at some of these in the Value Investing Strategies section later.
But first up, let’s cover the fundamentals of Value Investing in the next three sections.
2 Approaches to Value Investing
Not many people are aware of the existence of the two approaches to Value Investing.
Most investors understand the qualitative method, but few have heard about the quantitative method.
It isn't the fault of investors but rather, the success of Warren Buffett that puts the qualitative approach to the fore. Alvin wrote about investing in assets versus investing in earnings previously, this section goes deeper into that discussion.
Benjamin Graham coined the terms "Qualitative" and "Quantitative" approach to investing in his book, "The Intelligent Investor". We quote;
The Intelligent Investor
Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations. Corresponding with these two kinds of value elements are two basically different approaches to security analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.
Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years - in particular whether earnings will show pronounced and persistent growth. These conclusions may be based on a very careful study of such factors as supply and demand in the industry - or volume, price, and costs - or else they may be derived from a rather naive projection of the line of past growth into the future. If these authorities are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling...
By contrast, those who emphasize protection are always especially concerned with the price of the issue at the time of study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price - which margin could absorb unfavorable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company's long-run prospects as it is to be reasonably confident that the enterprise will get along.
The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth."
Qualitative Value Investing
- The certainty with which the long-term economic characteristics of the business can be evaluated;
- The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
- The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself;
- The purchase price of the business;
- The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
Such evaluations definitely require more guesswork and most people will fail terribly at it. Warren Buffett has a knack of getting it right in the businesses he understands. But most retail investors are not Warren Buffett. We do not have his skills and insights to project the future with a certain degree of certainty.
Even our highly intelligent and knowledgeable financial analysts aren’t able to do it well enough.
Without a doubt, the future returns are high with the qualitative approach. However, there is no point fantasizing about mouth-watering returns if we cannot do it accurately enough.
It will often backfire with disappointing returns, even worse than the stock index returns.
Quantitative Value Investing
Quantitative approach entails the analysis of the current state of the business.
While qualitative approach buys a business less than what it is worth in the future, quantitative approach pays less than what the business is worth today.
This requires the use of financial ratios such as Price-to-Book and Price-to-Earnings to evaluate the strength of the company.
Quantitaive approach’s risk management centralises on margin of safety as well as diversification.
- Buy as low as possible below the value of the company.
- Diversify into many undervalued stocks.
Below is a list of rules that Walter Schloss advocated (not exhaustive, he has more rules than these):
- Diversify into many stocks
- Stocks trading below book value
- Stocks with little to no debt
- Stocks trading at new price lows
Most of these rules are quantifiable. They are less subjective than the qualitative approach.
Quantitative value investing also doesn’t require the investor to know a company deeply to ascertain her future prospects.
The analysis of a company can be completed within minutes just by the numbers. Hence, the quantitative approach suits the investor with a full-time job, and he is unable to intimately keep up with in depth company research and developments.
Qualitative or Quantitative?
As authors of this guide, we are biased towards the quantitative approach.
It is our opinion that Quantitative Investing is more suited to investors who have not much time and experience, and yet it can yield decent returns of 12-15% per annum.
You will find that the financial ratios and value investing strategies that we share later in this guide are all tilted towards Quantitative analysis of Value Stocks. This is because the quantitative approach allows us to transfer the ability of profitable stock analysis to others. This is more difficult when it comes to the qualitative approach.
Of course, there is nothing wrong if an investor wish to pursue the qualitative approach and aim for a higher return than a quantitative approach could. However, the success rate of the former isn’t high.
Essential Terms for the Smart Value Investor
As you study about Value Investing, you will encounter “technical” terms or lingo that are usually used by Value Investors. Don’t be alarmed, here’s what they mean.
General Value Investing Terms:
The ratio used to measure your investment performance in comparison to market returns.
A positive alpha suggests that the investor has outperformed the market that he is comparing against.
The ratio used to measure volatility or systematic risk of your investment in comparison to the market.
Beta = 1 : the volatility of your investment(s) is the same as that of the market.
Beta < 1 :the volatility of your investment(s) is lower compared to the market, and vice versa.
Abbreviation for Capital Expenditure.
This refers to the company’s expenses used to upgrade or purchase physical assets which include equipment, properties or industrial buildings.
CAPEX gives investors a rough idea of how much the company’s newly acquired asset cost.
Abbreviation for Earnings Before Interest and Tax. EBIT is also known as “operating income” or “operating profit”.
It gives investors an idea of the company’s ability to generate profits by ignoring factors such as taxes and interest. You can calculate EBIT by taking Total Revenue – Operating Expenses
Abbreviation for Earnings Before Interest, Taxes, Depreciation and Amortization.
On top of Interest and Taxes, EBITA looks at the earnings of a company by ignoring additional debt related factors.
This is determined by the perceived value of the company. It could be valued based on the underlying assets or potential earnings. Value investors use a range of financial figures and ratios to determine the intrinsic value of a company. We share some examples of these financial figures and ratios in a later section of this guide.
Margin of Safety
Once a value investor determines the intrinsic value based on a set of rules and financial figures, he will compare the intrinsic value with the stock price. This difference is also known as the ‘Margin of Safety’.
The wider the positive difference between the intrinsic value and the stock’s current market price, the greater the margin of safety.
Undervalued / Overvalued
If the intrinsic value is greater than the market value, the stock is said to be ‘undervalued’.
Vice versa, if the intrinsic value is lower than the market value, the stock is said to be ‘overvalued’.
Common Terms Used in Financial Statements
As a value investor, annual reports or financial statements are your best allies. In order to master value investing and stock analysis, these are the terms you will need to know. They were originally compiled at
We have arranged them according to the sections in a financial statement.
Terms in the Income Statement
Revenue or Sales
Amount of money earned by the company.
Cost of running the company and business.
Difference between revenue and expenses.
Terms in the Balance Sheet
Assets that the company can use up or liquidate within the year of assessment. Non-current assets are the opposite.
Debts that the company needs to return within the year of assessment. Non-current liabilities are debts that the company takes more than the current assessment year to pay back.
Equity (aka Net Asset Value or Book Value)
Difference between total assets and total liabilities.
This is used as the 'intrinsic value' of a stock by some value investors. We'd prefer to include a wider margin of safety. You'll find out more in the Value Investing Strategies section later.
Paid in capital
The amount of money raised during the company’s Initial Public Offering.
Cumulative profits earned by the company after subtraction of dividends payouts.
Terms in the Cashflow Statement
Cash flow from operations
Cash generated from company’s core business.
Cash flow from investments
Cash spent on capital investment or other activities in investment vehicles.
Cash flow from financing activities
Record of activities involved in debts, loans and dividends.
8 Financial Ratios That Every Value Investor Absolutely Must Know
There are too many financial ratios available and this leads to “paralysis by analysis”. Here are 8 essential financial ratios that value investors should focus on.
PE ratio is the most common financial ratio to investors. It shows how many times of a stock's earnings you are paying for the stock.
For example, if the PE is 10, it means that you are paying 10 years’ worth of earnings.
The lower the PE, the better.
Let’s use an example to illustrate this.
You saw a house selling for $1m and the owner said it is tenanted. The owner tells you the rental is worth $5k a month. After you have factored all the costs in owning and maintaining the house, your net profit is $2k a month or $24k a year.
So the PE ratio for the house will be about 42. It will take 42 years for you to get back the worth of the house through a positive cashflow of $2k per month.
Although PE is a favourite ratio, it is ever changing.
i) Price is always changing
No one can predict how high the stock prices can go and although the PE can be high in your opinion, it can continue to go higher beyond your imagination.
ii) Earnings can fluctuate
The other factor that causes PE to change is the significant rise and fall in earnings. A company can be making a lot of money for the past 10 years but because of competition, they may lose market share and suffer a decline in earnings.
Hence, PE ratio is at best a view of the company’s and its stock’s historical performance. It does not tell you the future.
You would need to assess the quality aspect of the company – Can it sustain it’s earnings? Will the earnings grow?
Price / Free Cash Flow (FCF)
A positive P/FCF suggests that the company is making money even after expenditures on replacing or buying more equipment.
There is a belief that while it is possible to fake the income statement, it is harder to fake cash flow.
PE and P/FCF should tell the same story. You can use either or use both to detect any anomaly/divergence.
Price Earnings Growth Rate (PEG)
Some investors also argue that the PE ratio merely reflects historical performance. This is a better way to look into the future to get a sense if the company is a good buy.
PEG ratio = PE / Annual Earnings Per Share (EPS) Growth Rate
The house example above assumed that the rental does not grow over time.
But you and I know that it is not totally true. Rental may go up due to inflation. Likewise, growing companies are likely to increase their earnings in the future.
The PEG ratio lets you take earning growth into consideration. Let’s break the PEG ratio down.
EPS is simply earnings divided by the number of shares. But we need to look at the growth of earnings. So we have to average out the growth in EPS for the past few years.
For example, if the company has been growing at a rate of 10% per year, and its PE is 10, the PEG would be 1. In general, PEG ratio less than 1 is deem as undervalued.
However, it is important to understand that we are ASSUMING the company would continue to grow at this rate. No one can forecast earnings accurately.
Warren Buffett is smart in this area because he buys into companies with competitive advantage. Only this way, he can be more certain that the earnings will continue to grow, or at least remain the same.
Price-to-Book (PB) or Price-to-Net Asset Value
PB ratio is the second most common ratio. It tells you how much you are paying with reference to the book value or net asset value of a stock.
PB = 1, means you are paying an equal amount to the net asset value of the company.
PB > 1, means you are paying more than the net asset value of the company.
PB < 1, means you are paying less than the net asset value of the company. [Best Scenario!]
A word of caution when you look at NAV: these numbers are what the companies report and they may overstate or understate the value of assets and liabilities. In fact, not all assets are equal.
For example, a piece of real estate is more precious than product inventory. Rising inventory is a sign the company is not making sales and earnings may drop. Hence, rising assets or NAV may not always be a good thing.
You have to assess the asset of the company. The worst assets to hold are products with expiry, like agricultural crops etc. Also, during property booms, the assets may go up significantly as the properties are revalued. The NAV may tank if the property market crashes.
Debt-to-Asset or Debt-to-Equity
These ratios measure the debt level of a company.
Debt-to-Asset (D/A) = Total Liabilities / Total Assets
Debt-to-Equity (D/E) = Total Liabilities / Net Asset Value
Always use the same metric when making comparisons. Do not compare a stock’s D/A with another stock’s D/E!
Let’s go back to the example of your $1m house and remember you still owe the bank $500k, what would your D/A and D/E look like?
In the house example, your D/A would be 50% (assuming you only have this house and no other assets or liabilities for the sake of this example). This means: 50% of your house is serviced through debt.
In the house example, your D/E would be 100%. This means: if you sold your house now, you can repay 100% of the debt without having to top up.
As you can see, it is just a matter of preference and there is no difference to which ratio you should use.
Most importantly, the value of D/A or D/E is to understand how much debts the company is assuming. The company may be earning record profits but the performance may largely be supported by leverage.
Rising D/A and D/E rising is a bad thing. Leveraged performance is impressive during the good times. But during bad times, companies run the risk of bankruptcy.
Current Ratio or Quick Ratio
Current Ratio or Quick Ratio allows you to determine if a company has sufficient liquidity to manage their short term debts.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = Current Assets – Inventory / Current Liabilities
Quick Ratio is slightly more stringent than Current ratio. It is more apt for companies that sell products where inventory can take up a large part of their assets. It does not make a difference to company selling a service.
Long term debts usually take up the majority of the total liabilities. Although the company may have a manageable long-term debt level, it may not have sufficient liquidity to meet short term debts. This is important as cash in the short term is the lifeline of a business.
Again, it does not really matter which one you are looking at. In investing and in life, nothing is 100% accurate. Close enough is good enough.
Payout ratio measures the percentage of earnings given out as dividends.
A company can do two things to their earnings:
- distribute dividends to shareholders
- retain earnings for company’s usage
Once you know how much earning the company is keeping, you should ask the management what do they intend to do with the money.
- Are they expanding the business geographically or production capacity?
- Are they acquiring other businesses?
- Are they just keeping the money without having knowing what to do with it?
There is nothing wrong for the company to retain earnings if the management is going to make good use of the money.
Otherwise, they should give out a higher percentage of dividends to shareholders. Value investors or activists who want to unlock the value of companies tend to question the management on their payout and retain earnings. This allows investors to judge if the management really care about the shareholders.
Management Ownership Percentage
This is not a financial ratio per se but it is important to look at.
It is unlikely the CEO or Chairman would own more than 50% of a large corporation. Hence, this is more applicable to small companies.
Some investors prefer to buy into small and profitable companies where their CEO/Chairman is a majority shareholder.
This is to ensure his interests are aligned to the shareholders. It is natural for humans to be selfish to a certain extent and if you have the CEO/Chairman having more stake in the company, you are certain he will look after you (and himself).
Value Investing: How It Works
In A Nutshell
In short, the aim of Value Investors is to: “Buy Low, Sell High”.
Most people would have heard of this age old advice. But implementing it is not as straightforward. And most do this instead:
These are the two key questions that every investor seek to answer:
- “What price is considered low?”
- “What price is considered high?”
In value investing, we use the ‘intrinsic value’ to determine if a stock price is considered ‘high’ or ‘low’.
Ultimately, this is what we want to do:
We want to identify the intrinsic value or true value of a stock. And then, buy when the stock price is below the intrinsic value and sell when the stock price goes above its intrinsic value.
The greater the difference between the buy and sell points, the better because this difference is your return on investment.
In the next section, we share several methods that value investors use to determine the intrinsic value of a stock.
5 Characteristics of Value Investing
There are several characteristics or assumptions that Value Investors will have to understand and make.
These characteristics help to explain why certain stocks are said to be undervalued while others are not. Here, we list 5 key characteristics that value investors should know.
i) Irrational Market
We believe that the market is made up of irrational investors. Hence, prices on the stock market do not accurately reflect the true value of a stock.
A stock may be under-priced or overpriced mainly due to its investors’ sentiments.
And this creates opportunities for value investors who look to invest in undervalued stocks.
ii) Intrinsic Value
As value investors, we believe that every stock has its intrinsic value. This is the value of the stock and it is not related to the price that it is currently trading at.
We aim to look for stocks that are trading at a price below its intrinsic value. Pretty much like going into a store to look for items sold at a bargain.
If our research and analysis are done right, there is a chance for the stock price to rise to its intrinsic value over time.
iii) Margin of Safety
There is risk involved in any type of investing. It is no different in Value Investing.
No matter how in-depth your analysis is, you can never guarantee that a stock’s price will move in the way you’d predict it to.
Especially because of #1, some stocks’ true value will just never get realised on the stock market.
Hence to minimise our potential loss, value investors always look for a margin of safety; which is determined by the difference between its intrinsic value and its current price in the market.
Basically, we want a wider gap between the stock’s intrinsic value and its current price in the market. For example, Benjamin Graham was known to only invest in stocks that were trading at 2/3 of their intrinsic value.
iv) Time and Effort
This is not exactly the characteristic of Value Investing. However, all value investors who want to do well in value investing must be prepared to spend some time and effort.
Many value investors make use of fundamental factors to evaluate stocks, and there are little to no good fundamental stock screeners available. Even with a stock screener, value investors would still need to carry out their own due diligence to look beyond the numbers.
The market is irrational. It could take a while for a stock’s true value to be realised in the stock market. A value investor may need to wait for months or years before a stock can realise its true value for a positive return.
The waiting time for a positive ROI is something that most average investors find difficult to adhere to.
As mentioned, the market is irrational and it is driven by investors’ sentiments. This means that the price you see on the stock market and the performance of a stock in the market reflects how investors feel about the stock.
Value investors tend not to make investment decisions according to what everyone else is doing. In fact, we believe that you have to be a contrarian to succeed as a value investor.
And it is not easy.
To buy when the rest of the market is selling (i.e. when the market is plummeting), or to sell when the rest of the market is buying (i.e when the market is booming)
This process can be eased if you have a strategy with clear buy and sell guidelines.
5 Value Investing Valuation Strategies
Value Investing has been practiced for decades since it was conceptualised by Benjamin Graham.
Since then, many strategies have been derived to capture value from stocks.
It is important to note that different valuation methods may not agree on the intrinsic value. Each of these valuation methods have their pros and cons, and tend to work better for a subset of value stocks.
It is wise for a value investor to be well-equipped with different valuation methods before deciding if he should stick to any one method.
This is probably THE most valuable section of this extensive Value Investing guide. Because it's where we'll compile the popular Value Investing strategies as practiced by professionals and Value Investing Superstars.
From why the strategies work to how you can implement them, we reveal everything below.
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Before we continue, there's 1 important rule to remember when investing using any one method below:
You should use the same method to make the buy and sell decision for any 1 investment.
i.e. If you decide that stock A is worth investing using method 1, you should be using method 1 to decide when you should be selling stock A subsequently.
So, are you ready to learn some practical value investing strategies? Scroll on....
Net Net Strategy (Benjamin Graham’s Investing Strategy)
Benjamin Graham invested during the dark days of the Great Depression where many companies were going bankrupt each day. To enhance his possibility of success in the stock market, the Net Net Strategy was designed with a focus on safety.
Graham had to ensure that even if the company he invested in were to go bust, he would still ‘win’. He looked for companies with excess liquid assets that could cover all their liabilities and still payout to their shareholders, even if they were to go bust. Hence, Graham used ‘Current Asset’ instead of ‘Total Asset’ when looking for Net Net stocks.
With that in mind, the value of a Net Net Stock is determined by this formula:
You would want to take profit once your gains hit 50% or cut loss after 2 years regardless of the stock price.
Some features of Net Net Stocks we have noticed:
- Unfamiliar stocks: As they are unfamiliar, most investors shun them. Hence, they tend to be undervalued.
- Low liquidity: Insufficient sellers too, hence discourage buyers to participate.
- Small company: Most Net Net stocks are small companies and investors generally view them as risky. However, some of them could be debt free and financially stronger than bigger companies.
- Problems: Net Net stocks are usually companies which are facing short term issues that lead to a drop in their prices. Once the issue is resolved, we would expect the stock price to increase.
To learn more about Net Net Investing, watch our in-depth interview with Evan Bleker, founder of NetNetHunter. He uses the principles of Benjamin Graham’s Net Net strategy to find undervalued stocks in any market today.
Net Asset Value (NAV) Valuation
The Net Asset Value (NAV) method is less conservative compared to Graham’s Net Net Strategy. NAV or the book value is commonly used by many investors to get an idea of a company’s worth.
Net Asset Value of a stock can be determined by the following formula:
Discounted Cash Flow (DCF) Valuation
With the Discounted Cash Flow (DCF) method, investors discount future cash flow projections to get an estimated present value of a stock.
To get the Discounted Cash Flow value of a stock, use this formula:
We do not prefer this valuation method as there are 2 vague variables that we find difficult to determine; predicting future cash flow and determining a discount rate many years into the future.
However, DCF valuation reminds widely used. Many investors tend to get their estimates from professional analysts. It is easier to use DCF to evaluate companies with consistent free cash flow.
Concepts similar to DCF, one example is the Discounted Earnings Per Share (EPS).
For a quick video explanation of Discounted Cash Flow, watch this video: Discounted Cash Flow: How it works
To help you with DCF calculations, we have created an intrinsic value calculator. You can download it here: https://www.drwealth.com/calculator.
Price/Earnings to Growth (PEG) Ratio (Peter Lynch’s Investing Strategy)
Made popular by Peter Lynch, author of the book ‘One Up on Wall Street’. Alvin had summarised the 13 attributes of a great stock identified in Peter Lynch’s book.
This valuation is useful for growth stocks. Peter Lynch mentioned that "the P/E ratio of any company that's fairly priced will equal its growth rate."
The Price / Earnings to Growth (PEG) ratio is depicted as:
A stock with a PEG ratio of 1 is said to be fairly valued. Below 1 is undervalued and above 1 is overvalued.
Conservative Net Asset Value (CNAV) (Dr Wealth’s Investing Strategy)
We share about the CNAV strategy and our performance here: The CNAV Strategy.
The CNAV strategy is a form of value investing strategy, focusing on stocks with their price trading below their asset value (less liabilities). It is a quantitative method to keep our biases at bay in the process of stock selection.
The strategy consists of two key metrics and 3-step qualitative analysis.
Metric 1: Conservative Net Asset Value (CNAV)
We focus on the asset value of a stock and aim to pay a very low price for very high value of assets.
Hence, we only count the full value of cash and properties, and half the value for equipment, receivables, investments, inventories and intangibles (income generating intangibles such as operating rights and customer relationships. Goodwill and other non-income generating intangibles are excluded).
This means that the CNAV will always be lower than the NAV of the stock. This additional conservativeness adds to our margin of safety.
It is easy to find many stocks trading at low multiples of their book value but many of them deserve to be due to their poor fundamentals. Hence, we need to further filter this pool of cheap stocks to enhance our probability of success.
Metric 2: POF Score
A 3-point system based off Dr Joseph Piotroski’s F-score to find fundamentally strong low price-to-book stocks that are worth investing into.
While we emphasised on asset-based valuation, we look at earnings as well. The company should be making profits with its assets, indicated by a low Price-To-Earnings Multiple. Since we did not pay a single cent for earnings, the earnings need not be outstanding. Companies making huge losses would definitely not qualify for this criteria.
We have to look at the cash flow to ensure the profits declared are received in cash. A positive operating cash flow will ensure the company is not bleeding cash while running its business. The operating cash flow give us a better indication if the products and services are still in demand by the society. If not, the business should not stand to exist. A negative operating cash flow would mean that the company needs to dip into their cash to fund their current operations, which lowers the company’s NAV and CNAV. The company may even need to borrow money if their cash is insufficient and this raises further concerns for the investors.
Lastly, we will look at the amount of debt assumed by the company. We do not want the company to have to repay a mountain of debts going forward, especially if interest rate rises, it may dip into their operating cash flow, or worse, depleting their assets. Equity holders carry the cost of debt at the end of the day and hence the lower debt the better.
3-Step Qualitative Assessment
Step 1 – Check announcements and corporate actions since the data of Annual Report
Each annual report is dated and usually only available to investors three to four months after the reported date. The delay is to facilitate the auditing of the financial statements.
The figures of the company could have changed in a big way during the time difference between the day you look at the financial data and the date the statements were reported. Hence you need to go through the company announcements to ensure nothing major event has happened that could change your calculations.
Some of the key events that will affect CNAV calculations are:
- Changes in number of shares (rights issue or convertibles that dilutes shareholders’ interests)
- Large dividend distribution (significant cash is removed and lowers CNAV + NAV)
- Large acquisition (above NAV) or divestment of assets (below NAV)
- Issue of debt securities like corporate bonds (increase debt and lowers NAV)
Step 2 – Determine the major assets that you are buying
As our focus in CNAV strategy is to buy assets cheaply, it is thus important to know what assets we are actually buying.
The calculation of CNAV would classify the assets into the following 6 types, shown in the diagram below:
After you have determined the assets that you are buying, dig further into the details of these assets. For example, if it is properties that you are buying, find the locations of these properties and note the valuation dates. If the valuation of these properties coincide with property boom, you may want to discount these properties further.
If the company have high receivables, it is good to question whether they have an issue chasing their customers to pay. It is also crucial to make sure if a company has lots of inventories, they should not have short lifespan like perishables.
Bottomline, this step is to check if the assets are justifiable as the numbers presented them to be.
Step 3 – Establish the Trustworthiness of the Management
Our investment decisions hinged on the calculations and our calculations depend on the accuracy of the numbers reported in the annual reports. Hence, by inductive reasoning, our investment success depends on the management’s honesty in reporting these numbers.
This is a difficult item to measure and the best way we have found is to evaluate the management’s ‘Skin in the Game’. This simply means that we would check the management’s ownership of the company. A significant ownership in the company speaks louder than the words in their letters and their interest should be more aligned with shareholders since they are the biggest shareholders if they own more than 50%.
However, there have been cases whereby owner-cum-management short changed the minority shareholders by offering a very low price to buy up the remaining shares and delist the company. To minimise this risk is to consider a controlling shareholder do not own more than 70% of the company.
Value Investing: The Real Process
Value investing is not a bed of roses. It is not likely for a stock price to immediately surge the moment you invest in it. Some stocks take years to realise their true value.
Here’s are case studies of our experience in value investing. You can find more of these case studies at https://www.drwealth.com/case-studies/.
[Case Study] TSH (SGX:574)
Buy stocks cheap and sell them dear.
How difficult can it be?
Simple doesn’t mean it is easy.
Value stocks are very uncomfortable to buy. An unprepared investor would have a lot of self-doubt and might lose confidence when bad events arise.
The case in point revolves around TSH, a stock listed on the Catalist (the secondary board of the SGX).
TSH’s market capitalisation was about S$30 million when we were first look at the stock in 2014. It was a very small cap stock which most professionals would not even take a glance at it.
Though a small company, TSH had 4 business streams.
Homeland security arm served the Defence sector, disposing ammunition and constructing civil defence shelters. This business segment also supplied and choreographed fireworks display.
Consumer electronics arm designed headphones, earphones, speakers and accessories for mobile phones and tablets. These products were made in China and sold in the U.S. through a distributor.
The property arm developed properties in Australia.
Lastly, the consulting arm organised sports event such as POSB PAssion Run for Kids, PAssion Fun Around the Bay, Home TeamNS-New Balance REAL Run, Orange Ribbon Walk, Run for Hope, Green Corridor Run, Jardine’s MINDSET Challenge (Vertical Marathon), and Love Your Heart Run.
It appeared to me that the Company was not focused. A small company shouldn’t be doing so many unrelated businesses because there weren’t enough resources to do everything well.
We practise a version of value investing known as the Conservative Net Asset Value (CNAV) strategy. The approach focused on buying companies below their asset value, as oppose to valuing companies based on their earnings.
Slightly more than 2 years ago, the Net Asset Value (NAV) of TSH was $44.6m. The assets included $23.8m cash and a freehold building worth $8.8m.
Market capitalisation was only $30m, less than the NAV of $44.6m. An undervalued stock indeed.
For the graduates of our course, you would understand if TSH had a CNAV2 discount of 19% and a POF Score of 3.
We bought some TSH shares at S$0.124 on 31 Jul 2014.
A String Of Negative Events
An undervalued stock doesn’t mean it can only go up in price.
On the contrary, the share price fell after we have invested in TSH.
We had a paper loss of 30% as the share price dropped to $0.086.
What happened? What should we do?
Some investors may panic. Some may be in denial.
We actually added our position in TSH on 15 Feb 2015 because the assets were still intact and the shares just got cheaper. Moreover, the CEO of TSH added a large position in Dec 2014. We do not usually average down though and we believe most investors shouldn’t do it.
The annual report for FY14 was released in Apr 2015. Operating cash flow was negative and we should have cut loss given our quantitative criteria. We analysed the situation and decided not to because the operating cash flow was impacted by a one-off large purchase of development property. Without this, the operating cash flow would remain positive.
In 4 Aug 2015, TSH invested $5m into an oil & gas company listed on the Bursa Malaysia. The Company was Hibiscus. It was a bad timing as we know that the crude oil prices tumbled in end-2015.
It was not easy for most investors to swallow one bad news after another. It would be normal to start thinking that you have made a mistake and indulge in self-blame for not identifying the risks in advance. How many investors would have given up hopes on the stock and suffer in silence?
The series of events are plotted on the following stock chart after the investment was made.
The Change Of Fortune
Somehow, all of a sudden, the management seemed to be enlightened and took a series of actions that benefitted the shareholders.
On 23 Dec 2015, the management sold away all the Australian properties and decided to close down this business segment. They made a small loss from this.
This kicked off the liquidation of other businesses and assets of TSH, unlocking value for the shareholders. The management declared a $0.03 dividend per share, which was a 27% dividend yield based on our average buy price of $0.108.
Of note, the homeland security business was sold to the CEO of TSH and the consumer electronics was sold to a third party. The freehold building was sold for $16m at the prevailing market value. The gain was around $7m.
TSH became a cash company without any business operations. The management declared a special dividend and capital reduction of $0.1232 per share. This would return 82% of the NAV to the shareholders. With such a large distribution, I believe it is unlikely the management is going to buy a business and stay listed. Eventually all the money would be returned to the shareholders.
The revised NAV per share was S$0.15 and we decided to sell off at this price with a total percentage gain of 67%.
Below is the summary of asset disposal and value unlocking sequence:
It is true not all stocks would turn out as well as TSH. Some may become a permanent loss. Hence, we must manage portfolio properly – diversify sufficiently, cut loss when necessary. Having a time stop to exit is also important to avoid value traps.
[Case Study] Chemical Industries (SGX:C05)
Read it now: How we made 100% gain on a falling business
If you thought TSH was an exciting rollercoaster ride, this next case study will give you a deeper insight into being a real value investor.
Similar to TSH, Chemical Industries gave us an emotional ride as they churn out pieces of negative news after we had invested.
Unlike TSH, with each negative news the stock price of Chemical Industries went up.
It's a great case study to remind ourselves that we can never predict what happens in the stock market. You can read it here: Chemical Industries: How we made a 100% gain on a falling business.
As a value investor, you have to go against the herd. Most of the really cheap stocks are small caps and many would find them uncomfortable to buy. It is also counter-intuitive to buy into problems. But it is the presence of problems that resulted in cheap stock prices.
To make it even tougher, the stock price may continue to disappoint after you have invested in a value stock and result in a large loss, albeit on paper. It makes you doubt your investment position.
You need a lot of confidence and conviction to stick to your investment process. One day, things might just turn rosy and allow you to sell for a handsome profit.
Why are these case studies so negative?
As educators and investors ourselves, we believe in warning fellow investors of the true journey of investing.
We don't believe in over-promising high returns that are not backed by our own results. Instead, we show the ugly truth of investing and want our students to come in with the right expectations.
There are many beautiful investing stories out there, you will definitely encounter some of them as you learn about investing.
We want to be the balance and show the painful emotional journey that all investors have to be prepared to go through here.
Value Investing: How to Get Started?
Now that you have a basic understanding of how Value Investing works, all that is left is to take action and start looking for undervalued stocks in the market.
The Most Common Mistake of an average Investor
In investing, there are many strategies that work.
Some of these strategies work better in certain market conditions. Some strategies work better for certain types of stocks. (i.e. the CNAV strategy is efficient at finding undervalued stocks)
Most investors find themselves shopping for strategies from various mentors. And at the end of the day, have invested in a bunch of stocks that were analysed using different strategies.
Their portfolio end up like a messy patch work of stocks.
And when the market drops as a whole, they are not able to determine which stocks to sell or keep.
#1 rule of thumb
When investing in stocks, always make sure that your buying and selling decisions are made using the same strategy.
Because the same stock can appear to have ‘Great Potential” using strategy A while appear to be a “Bad buy” using Strategy B if the philosophy behind these 2 strategies are different.
Learn a complete value investing strategy and stick to it
The CNAV strategy that we use is just one of many value investing strategies that work. Dr Wealth does not believe in using leverage as it increases risk as well.
Instead, we aim to become functional ‘part-time’ investors who are able to pick undervalued stocks and grow our portfolio at a consistent rate of 10-15% every year.
This means that we free up a lot of our time – since there is no need to constantly monitor the stock market - to be able to go on with our daily lives.
Thus far, the Conservative Net Asset Value (CNAV) strategy (along with 2 other strategies) have allowed us to beat the market since 2014 by tapping into stocks with Value and Size ‘factors’.
Other than Value, we are also looking out for dividend stocks with the 'Profitability' factor and ETFs that allow us to tap into the 'Momentum' factor. We've compiled 10+ years of investing experience into a single and easy to understand guide here: The Complete Guide to Factor-Based Investing
If you learn better at a live class, with a trainer who can break down everything clearly for you, explore our FREE Factor Based Investing Introductory Course.
It doesn’t cost thousands of dollars to gain the ability to invest successfully. In fact, the Factor Based Investing Introductory Course is free and was created to give new beginners an overview to successful value investing and investing in general. Commit to your education, free up 2.5 hours and kick start your investing journey now. Reserve a seat.
Useful Resources for the Value Investor
This section lists additional useful resources that are catered for the value investor. All resources are listed alphabetically. For more investing and trading resources from financial commentary, economic data to charting tools, go to the Ultimate Investing Resource Directory.
- Stock Screeners
- Portfolio Tracker
Deep Value Stock Screener. Find undervalued activist and takeover targets
Stock screener for investors and traders, financial visualizations.
Quickly and easily select stocks based on key metrics like share price, market cap, P/E ratio, dividend yield and more.GuruFocus
The All-In-One Guru Stock Screener. The screener now has more than 120 filters for you to screen your favorite stocks.
Rank stocks based on Jitta Score and Jitta Line to give you the opportunity to “Buy a Wonderful Company at a Fair Price”.
Get real-time stock quotes, stock charts, company fundamentals, financial results and market moving financial news.
Comes with a free 14 days trial. You can screen stocks using the strategies from different gurus inside Stockopedia.