Value Investing in Equities: Principles and Best Practices for Long-Term Value Creation

value-investing-in-equities-principles-and-best-practices-for-long-term-value-creation-870

Investing in equities can be likened to navigating through a labyrinth, filled with paths that lead to an enticing assortment of returns, each path characterised by varying degrees of risk and reward. One of the most reliable paths through this maze, particularly for those with a long-term perspective, is Value Investing. Value investing, a strategy that seeks to capitalise on the under-pricing of stocks relative to their intrinsic value, is a strategic approach pioneered by the revered Benjamin Graham and subsequently popularised by his most famous student, Warren Buffet.

value-investing-in-equities-principles-and-best-practices-for-long-term-value-creation-img1

Warren Buffett, often referred to as the "Oracle of Omaha," is widely recognised as one of the most successful investors in history. Known for his value investing strategy and long-term approach, Buffett is the chairman and CEO of Berkshire Hathaway, a multinational conglomerate holding company.

His investment philosophy, emphasising fundamentals and intrinsic value, has inspired countless investors worldwide.

Benjamin Graham, known as the "Father of Value Investing," was an influential economist and professional investor. He is best known for his books "The Intelligent Investor" and "Security Analysis," which laid the foundation for modern value investing. Graham's principles, focusing on long-term investments and the concept of "margin of safety," have been the cornerstone of many successful investment strategies, including those of Warren Buffett.

Unveiling Value Investing

Intrinsic value refers to the actual or true value of a company or an asset. It encapsulates all aspects of a company's business: tangible assets like plant and machinery, intangible assets like patents and trademarks, the company's financial health, earnings potential, management quality, industry position, and other pertinent factors. It is the value that a seasoned investor, such as Warren Buffett, might assign to a company after performing rigorous analysis.

The importance of calculating the intrinsic value lies in its use as a benchmark to compare with the current market price of a stock. If the intrinsic value is more than the current market price, it implies that the stock is undervalued, providing an investment opportunity for value investors. Considering all aspects of the business, including tangible assets, projected earnings, and intangible elements such as the quality of its management.

The Genesis of Value Investing

The concept of value investing traces its roots back to the 1930s when Benjamin Graham and David Dodd expounded on it in their seminal 1934 work, "Security Analysis." Graham's core investment philosophy revolved around investing with a “margin of safety,” ensuring an adequate level of protection against capital loss.

Core Principles of Value Investing

For a successful foray into the realm of value investing, understanding and adherence to the principles are crucial. These principles include:

  1. Intrinsic Value: The fundamental principle of value investing lies in identifying stocks trading at a price below their intrinsic value. The intrinsic value can be determined through various methods, including the Price to Earnings (P/E) ratio, Book Value, Dividend Discount Model, or Free Cash Flow.

  2. Margin of Safety: Graham's 'Margin of Safety’ principal advocates for purchasing stocks at a price significantly below their calculated intrinsic value. This safety buffer serves to protect investors from adverse events or errors in the estimation of the intrinsic value.

  3. Long-term Orientation: Value investing is not a 'get rich quick' scheme. It is a long-term investment strategy that demands patience to allow the market to correct its mispricing, leading to an appreciation in the stock's price.

  4. Contrarian Approach: Value investors often go against prevailing market trends. They make investment decisions based on diligent research and analysis, and not on the popular sentiment or the latest market trends.

  5. Focus on Financially Stable Companies: Value investors seek companies with robust financial health, characterised by low debt, consistent profitability, and a history of strong earnings.

  6. Importance of Management Quality: The role of competent management cannot be overstated. Value investors favour companies helmed by a proven, honest, and efficient management team.

How to Calculate Intrinsic Value

There are numerous methods used in practice to calculate the intrinsic value of a stock. The complexity and suitability of these methods vary with the nature of the business, the industry in which it operates, and the investor's understanding of the business. Here are a few popular ones:

  1. Price to Earnings (P/E) Ratio: This is one of the simplest ways to determine a company's intrinsic value. You can calculate a stock's intrinsic value by multiplying its P/E ratio by its earnings per share (EPS). For instance, if the average P/E ratio in the industry is 20 and the company's EPS is RM5, the intrinsic value would be 20 * RM5 = RM100 per share.

  2. Discounted Cash Flow (DCF) Method: The DCF method is a more sophisticated technique that calculates a company's intrinsic value by estimating the present value of its future cash flows. The DCF formula is:

    • Year 1: RM100,000/ (1+0.10) ^1

    • Year 2: RM100,000/ (1+0.10) ^2

    • Year 3: RM100,000/ (1+0.10) ^3

    • Year 4: RM100,000/ (1+0.10) ^4

    • Year 5: RM100,000/ (1+0.10) ^5

  3. Book Value: This is the value of the company as per its balance sheet – total assets minus intangible assets and liabilities. Though it is a rudimentary method, it is often used as a quick and dirty way to determine a company's worth, particularly in capital-intensive sectors like manufacturing and banking.

  4. Dividend Discount Model (DDM): This method is specific to companies that regularly pay out dividends. The intrinsic value of the stock is the present value of all future dividends. Like the DCF model, it requires assumptions about dividend growth and a discount rate.

What to Know Before Embarking on Value Investing

Value investing involves comprehensive research and analysis, patience, and discipline. Meticulous due diligence is necessary as not every undervalued company represents a promising investment.

value-investing-in-equities-principles-and-best-practices-for-long-term-value-creation-img2

Some companies might be undervalued for a valid reason, like inefficient management, loss of market share, or financial instability. Therefore, a thorough understanding of the company's financials, operations, and overall industry landscape is indispensable.

  • Educate Yourself - delve into the world of finance and investing. Books, online courses, seminars, and even financial news can augment your knowledge. For our favourite books and articles on value investing, do look out for the section below.

  • Identify and Analyse Potential Investment Opportunities - Identify and Analyse Potential Investment Opportunities - look for companies with sound business models, good prospects, and whose stocks are trading below their intrinsic value. The valuation can be done using financial ratios and valuation models.

  • Determine the Margin of Safety - the margin of safety is the difference between the stock's intrinsic value and its market price. The wider the margin, the lower the risk.

  • Invest - after you have identified an undervalued stock with a comfortable margin of safety, it is time to invest.

  • Monitor Your Investment - keeping track of your investments and the company's performance and standing in the market is crucial.

Recommended Books on Value Investing
  1. "The Intelligent Investor" by Benjamin Graham - Often referred to as the bible of value investing, this book lays the foundation of Graham's philosophy of "value investing" - a strategy to make long-term investments.

  2. "Security Analysis" by Benjamin Graham and David Dodd - This is a more advanced text that delves deeper into the analysis required for value investing.

  3. "The Essays of Warren Buffett: Lessons for Corporate America" by Lawrence A. Cunningham - A collection of Buffett's letters to Berkshire Hathaway shareholders, offering insights into his investment strategies and views on corporate governance and finance.

  4. "Common Stocks and Uncommon Profits" by Philip Fisher - Fisher's book is renowned for its principles on qualitative investing, focusing on companies with rapid growth potential.

  5. "Value Investing: From Graham to Buffett and Beyond" by Bruce Greenwald et al. - Greenwald offers a contemporary look at the principles of value investing and includes profiles of successful value investors.

Recommended Article on Value Investing
  1. "The Superinvestors of Graham-and-Doddsville" by Warren Buffett - An article that defends the value investing approach and illustrates its effectiveness through various case studies of successful investors.

Value investing is a strategic, long-term approach to investing. It may not promise quick gains or thrill, but over time, it can build substantial wealth for the patient investor. As Buffett said, "Investing is not rocket science, but there is no easy button." To be a successful value investor, it takes time, effort, patience, and the ability to remain calm when the market is not. Embrace the journey and may your pursuit of value lead to fruitful returns.

* Some financial products and services may not be classified as Shariah-compliant. Please research carefully before making any financial decisions

Details
Published Date
23 Sep 2024
Source
BURSA MALAYSIA
Proficiency Level
Professional
Share

Related Articles

Discover other related articles