Value investing is trying to buy companies for less than their intrinsic value– what they should be worth. There are different ways to value a company.
If you sold off all its assets and paid off all its liabilities you would be left with a pile of cash. If you buy companies at half their liquidation value, then you would theoretically make money. I generally don’t like this style of investing because I am greedy and like strategies with higher rates of return. The problem with trying to find companies like this is that this kind of analysis is easy to do, almost everybody knows about it (thanks to Ben-Graham and Warren Buffett), and so people buy these stocks and the price goes up. So you don’t have a lot of room for profit. Yes, these types of stocks still exist. You can find them on shady exchanges like the TSX Venture exchange. Institutional investors won’t touch those stocks and they can be overlooked. But, I don’t like them.
You look at a company’s price to earnings ratio (i.e. its P/E multiple), EBITDA ratio, free cash flow ratio, or some other number. You company that number to its peers’ number. Usually there is a range. You assume that your company should fall at the bottom of that range, the middle, or the top (based on how good it is). And that becomes what they company “should” be worth.
The reason I hate this method is usually because it is applied with zero understanding of the industry and the companies involved. There is usually a reason why the numbers are different between companies. But if you are ignorant of those reasons, you might simply assume that your company should be “average” or fall at the bottom of the range. This may be highly inappropriate if say you are looking at a mining company, and its mine will only make money for 1 more year while everybody else’s mine will make money for 10+ years. The mine that is about to be closed may have a PE ratio of 1, while everybody else’s mine may have a PE ratio of 10 or higher. And it could be that none of them are over/undervalued.
Discounted cash flow
One way to measure a company’s intrinsic value is to figure out how much cash it is going to make in the future. A dollar ten years in the future is not worth as much as a dollar now, since money now can be used to earn interest and will be worth more in the future. So, future income should be discounted to the present. You factor out the interest so that the two are equivalent. This is the discounted cash flow (DCF) method of valuing a company.
The obvious problem with the DCF method is that it is hard to predict the future. And usually the problem with most value investors is that they get overly optimistic about a company. And once you are optimistic about a company, you can easily make your DCF model make the company seem undervalued. Because the new management will “turn the company around”, their performance will “revert to the mean”, or some other rationale is given that may or may not happen.
What I look for
To me, the most important factors to look for are:
- Does the company earn a lot of money for every dollar it invests? e.g. high return on invested capital. Can the company’s earnings grow really fast over time?
- Does the company have some sort of special advantage over its competitors?
- Is management honest?
- Is management trying to maximize shareholder return?
1- Suppose you put money in the bank and get 3% interest on it. Suppose a company expands its widget factory and gets the equivalent of 15% interest on it. Obviously, the higher return is better.
But this is before the magic of compounding. Over time, the growth is theoretically exponential. In 10 years, $1 invested in the bank account will be worth $1.34. Whereas $1 invested in expanding the widget factory (and re-expanding it) will be worth $4.04.
2- A lot of people have figured out that growth matters and will usually chase it too. So whenever a company makes a high return on the money it invests, there will almost always be imitators that spring up. The pattern is usually this: first there are the innovators, then the imitators, then the idiots. More and more people flooding into a market tends to drive returns down, possibly until everybody is losing money. I want to buy stocks where this won’t happen. I want to buy growth stocks that will keep growing for a long time. To me, value investing should be about buying these growth stocks cheaply.
Examples of special advantages that can’t be imitated or are very difficult to imitate:
In the railroad business, almost nobody will build a railroad to compete with yours because it would cost too much and the return would be low with competition. So railroads only compete with other forms of transportation (e.g. air for passengers, trucks and ships for goods/materials). Rail has a cost advantage over other forms of transportation, so it has an inherent advantage over the competition that is impossible for them to duplicate.
Microsoft Windows has an advantage over Linux and OS X because there is a huge amount of software out there that only runs on Windows. Their competitors just can’t duplicate this advantage.
3- If management isn’t honest, then they may engage in accounting shenanigans to make their company look better than it actually is. This is risky for investors because they may overpay for a stock.
There may also be fraud occurring. If fraud is discovered and the company announces that it actually isn’t making any money at all, you will lose a huge amount of money.
Also, insiders may simply overpay themselves and/or skim money from the company. Sometimes these shenanigans are disclosed in the Related Party Transactions section of the company’s financial filings. This obviously reduces the amount of money that shareholders make.
I don’t want to invest in a company where dishonestly works against me. (*I do speculate on companies where I think dishonesty works in my favour.)
4- A lot of the time, management is not actually trying to maximize shareholder return. Some of them simply use their company to increase their status. Oftentimes, they want to build an empire. Or, they simply follow the herd. Whenever they do these things, they aren’t figuring out how to get the best return on the money they invest (see #1).
Of all the stocks out there, probably >90% of the stocks out there don’t meet these criteria and <10% do. By definition, not all stocks can meet the criteria for #2 (special advantages over everybody else). If you think that more than 10% of the stocks out there meet these criteria, then you are probably doing something wrong. They can’t all be the best.
Once you identify the best stocks, you simply wait for them to get cheap and then buy ’em. If they aren’t cheap, it’s important to do nothing and wait.