Asked on 03 Apr 2019
Good question. To understand more, read on - i will use ridesharing to explain this.
Firstly, let me comment: that’s how anyone makes money in general. You acquire an asset for $X (your own time, other people’s time, labour, raw material etc), and perhaps after some processing (or rebranding), sell it for $Y (hopefully Y>X). Buy low, sell high. Or put another way: buy at a price, sell at a higher price.
Value investing is just one of many stock-picking strategies that people have come up with, in order to achieve this outcome (buy at $X, sell at $Y where Y>X)(note: not necessarily in that order in a process called shorting), and the mindset behind it is different from other strategies.
To understand value investing, you have to understand some fundamental truths about the stock markets (and perhaps about humans). With the popularity of ride-sharing apps, i will use grab as example.
Caveat: I am going to use some slightly inaccurate terms below, but it gives you the general gist.
Truth #1: The price in stock markets has “surge pricing” built-in. Shocking? Well, basically what i am saying is that the “equilibrium” price of a stock is determined by demand and supply of the stock. If everyone’s buying and nobody’s selling, price goes up. If everyone’s dumping and nobody’s willing to buy (or just lost their jobs), then price goes down. Surge-pricing.
Truth #2: Humans behave inconsistently and consistently at the same time. They hate surge pricing generally (it’s the same distance, how can it cost $12 before rain, and $30 during rain?), and yet contributes to it (everyone is buying this stock, must be good!)
Truth #3: The stocks you buy represents actual fractional ownership of a real, living and breathing, money-making entity - one with a track record, and actual, real-life, intelligent humans working there for a large part of their waking hours. And for the most part, has predictable growth.
These 3 truths, when combined together, simply tells you this: The price of the stock you see fluctuates on a daily basis (because of “surge-pricing”), but once you buy it, you own an actual business with predictable growth. “Price is what you pay, Value is what you get”.
To succeed at value investing requires identifying “mispricing” - that it’s selling below its actual value (“Jurong to Orchard is only $9! Good deal!)(note: actual trip on gojek). Bargain hunters in general, are genetically primed for this activity. Somehow they know the “intrinsic worth” of an item, and when they see it being sold cheaply at a flea market, or a “closing-down” sale, they snap it up, safe in the knowledge that they have bought something that can be resold at a higher price because of its “intrinsic value”.
To explain how to calculate the intrinsic value, will take up many thousands of words. But I assure you, no differentiation or integration required. All of us intuitively can feel “fair value” or “good deal” when it comes to a ride because we do it regularly. When it comes to investing, it’s the same: Do it regularly, study the market, understand what’s fair value and what’s a good deal or when it’s ripping you off, and you will do well in the stock market. Unfortunately, most people study the prices between gojek and grab and comfort more regularly than they do investing.
And THAT is value investing, using ridesharing as an example.
Let me know if this analogy works!
Yes, value investing is a buylow, sell high strategy, where value investors aim to invest in stocks that are "undervalued" by the market. To determine whether stocks are "undervalued", investors carry out stock analysis and valuation to determine the stock's intrinsic (true) value.
Here are some guidelines to apply value investing
Invest in a business with a strong moat giving it a strong/ durable competitive advantage. This requires investors to understand the company, its business, products/services, the industry, the management, how the company generates revenues etc.
Assess the intrinsic value of the company. One common method is the discounted cash flow method which gives the free cash flow (residual cash left in the business).
Purchase stock with a significant margin of safety (significant discount to intrinisic value). Having a margin of safety gives investors a buffer to account for any errors, wrong assumptions and unforeseen consequences.
Value investing is the selection of stock that appear to trade for a lower value than their book values. It is usually about looking for stocks in the market that is believed to be undervalued.
Here are some areas that investors usually look at to find undervalued stocks
Below average price-to-book ratios
Lower than average price-to-earnings (P/E) ratios
Higher than average dividend yields
However, it is actually not that easy to be able to spot an undervalued stock as estimating the true intristic value of a stock is not easy.
Value investors usually seek to make profits from market overreactions which typically comes from the release of the company's earnings report.
The best way to think about value investing is to compare it with discounted shopping.
There is a new Smart TV released in the market. As a shopper, I did some research and found that it has several awesome functions that I like. But when I see its price tag, I gawked at the lofty price; probably because it is still a new product and there's a lot of hype about it. I thought to myself, it can't be worth that much.
Over the next few months, I keep a lookout on that TV and monitored its price. Finally, the Great Singapore Sale arrived and there was a 15% discount from its recommended retail price. Sounds like a steal!
But I wait out for a deal. I window-shop and stared at the 15% discount daily until I found a display unit selling at an additional 10% off.
Ahh! I thought to myself. The Smart TV that I've been watching out for the past few months is finally selling at a solid 25% discount; its awesome functions and features remain unchanged. Then, I swoop in to buy the discounted unit.
In sum, value investing is like looking for a deal. You want to buy a good stock with solid fundamentals at a fair (or even discounted) price.
I wrote a guest post for dollars and sense before sharing about what is value investing and why does it work.
Here's an exerpt:
"Value Investing is a stock investing methodology that is practised by many successful investors, including Warren Buffett and Seth Klarman.
In Value Investing, you are essentially buying a stock that is worth $1 for 50 cents. There are many reasons why this can happen.
One of the reasons is that many stock investors do not understand what they are investing in. This forces them to sell a good stock at a cheap price when the market turns against them. This is when the practitioners of value investing will take advantage by buying the stock that are cheap.
You should also note that value investing is fundamentally different from stocks trading. While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price."