Value Investing is Still Hot
Beat the Market with these Fundamental Investment approaches
What is Value Investing?
Value investing strategy aims to invest in undervalued stocks - the stocks whose current market price is lower than their fundamental value.
Why are these stocks undervalued?
Since the average investor is considered irrational, who overreacts to news - good or bad - not every stock is fairly valued.
How It Works?
As a value investor you are seeking the ignored stocks - Diamond in the Dirt.
In financial terms, these are the stocks trading for less than their intrinsic value (what their value should be).
And when you find a value stock, you are getting good quality at a discount.
How to do Value Investing?
Invest in quality stocks, selling at a discount.
Value Investing = Cheapness + Quality
Value investors buy stocks that they deem cheap (compared to their intrinsic value), and sell (or sell short) those they deem expensive.
Note: cheap stocks is not synonymous with bad quality stocks
How to find Value Stocks?
To find valued stocks you need to view the market participants as irrational.
Value investment fundamental investment strategies go against the Efficient Market Hypothesis (EMH), which states that the price of a security incorporates all available information.
Price = Value
Value investing assumes that due to sentimental behavior of investors the price of a security does not necessarily represent its intrinsic value.
Value investors mainly use a combination of the following indicators to find undervalued stocks;
Lower than average price to book ratio
Lower than average price to earnings ratio
Higher dividend yields
If these values are higher or lower enough for a stock then it is worth considering.
But there’s a problem.
Intrinsic value is subjective.
Give two analysts the same company information and they will probably come up with different intrinsic values.
As they say, ‘investing is a combination of Science and Art.’
To deal with this problem of estimation, investors use ‘margin of safety,’ which is simply the difference between current market price and the estimated intrinsic value.
Investors set this margin based on their risk preferences, so that they can invest with minimal downside risk.
Margin of safety concept was made popular by Benjamin Graham, a.k.a Father of Value Investing.
Later, investors such as Warren Buffett and Peter Lynch (both are wall street gurus) embraced this strategy and found tremendous success.
What is Value Investing Strategy?
Since intrinsic value is subjective, investors follow their own strategies to find valued stocks.
However, an over-simplification of value investing could be;
Strategies vary according to the investors. Some are simple, some are complex, while some are comprehensive.
To find the right one, investors should compare performances of different strategies.
For instance, at SAMT AG, we use rule-based systematic investment in quality stocks, which has shown higher returns than the market, across all investment cycles.
Also, we normally exclude risky stocks, stock picks, stock bullets, stock recommendations, stock market tips, and recommendations from analysts.
What is the future of Value Investing?
Repressive monetary policy is forcing investors to find investment venues outside the immediate realm of interest rates.
Which is why our fund managers focus on productive capital - direct participation in the best companies (quality stocks).
Value investing is not a static concept.
Market efficiency theory aside, many investors who have established equity strategies, have generated above average returns at low risk.
Warren Buffett, Joel Greenblatt, Peter Lynch, James O'Shaughnessy and others have beaten the broad market (such as the S&P 500 index) over a long period.
How did they achieve such returns?
Through active stock selection based on specific features and ratios.
Investing in undervalued stocks has allowed Warren Buffett to become one of the top three richest person in the world.
The following graph shows the performance of Buffett's investment firm Berkshire Hathaway (Warren Buffett Fund) in the past four decades.
Berkshire Hathaway vs. S&P 500
Bear in mind that value investing has evolved. The strategy might seem concentrated in equities however, you can easily find other venues.
For example, you might invest in a value mutual fund or value index fund instead of buying stocks.
Also, when one considers the concepts of margin of safety and intrinsic value it might seem like value investing is strictly for the long term.
Although value investing works best for the long term, you can integrate short term strategies as well.
This long-term and short-term combo is used by many hedge fund managers, and some of these have found great success with value investing.
Finding Undervalued Stocks - The Investor's Edge
Screening companies based on the following factors can give you the edge in identifying undervalued stocks;
Strong growth companies
Slow growth companies
Focus on stable companies that are ‘innovation leaders’ and have high-growth values.
However, you should clearly define your growth criterion, especially for categories 1 to 3.
What makes a Company unique? How to develop a successful Portfolio?
When it comes to successful investors, Warren Buffett is the nonesuch.
His letters to the shareholders of Berkshire Hathaway reveal a lot about how he finds companies to invest in.
Buffett follows a two step audit process:
- Examine the business type and economic situation
- Price calculation and future enterprise valuation
Just like his mentor Benjamin Graham, Buffett seeks companies that offer margin of safety.
“High quality firms exhibit high risk-adjusted returns”
Research by Asness, Frazzini and Pedersen, Quality Minus Junk, concludes that the ‘quality characteristics’ provide significant excess returns.
In their study, these characteristics were applied to 24 countries, and 23 (with the exception of New Zealand) confirmed the effectiveness of these quality characteristics.
For instance, Buffett's Alpha, a working paper by Frazzini, Kabiller and Pedersen, points to certain quality factors that are crucial for portfolio performance based on this type of criterion.
How do professionals find Undervalued Stocks?
Many analysts compare value investing vs trading, as if they are mutually exclusive.
But, they are not.
In fact, finding value stocks is half the battle won, the rest depends on the efficiency of trading.
The principles of value investing will remain unchanged for the most part.
However, the rules keep changing according to the changing market conditions.
At SAMT AG we use the following quality criteria (which is analogous to Buffett's Moat Theory) for selecting undervalued stocks;
Does the company...
- Have a stable history?
- Have monopolistic market position?
- Have an established brand or portfolio?
- Have good long-term competitive advantages and prospects?
- Have extensive freedom in pricing power while adjusting for inflation?
- Have management of integrity (entrepreneurial) or owner oriented? Or is it an administration after self interests?
- Have a management which makes rational decisions about acquisition and distribution?
Factors to evaluate financial health of a company:
- Debt to Equity (D/E) ratio
- Has the return on capital been increasing or decreasing over the years?
- Does the company operate with constant or increasing net profit margins?
- Does the company have stable growth in sales and dividends?
- What is the profit growth of the company? Is it sustainable or increasing?
- What is the relationship between net cash flow, cash flow margin and capital expenditure ratio?
Enterprise value is the total value of a company, which tells the story of company’s debt, cash and minority interests.
The following steps are extremely useful in studying the enterprise value;
- Using the Discounted Cash Flow (DCF) method to determine the future enterprise value
- Calculating initial yield
- Compliance with the margin of safety, price-to-revenue ratio, price-to-earnings ratio and others
Analysis by the Portfolio Manager, James O'Shaughnessy shows how important price-to-revenue ratio is for valuation.
His extensive study proved that companies with market cap of more than $150 million and a high price-to-earnings ratio significantly underperformed the market.
O'Shaughnessy also points out the financial factors that should be used to generate lasting returns which exceed the broad market.
Fundamental Trend following Trading with Options expansion
The steps below show how we structure fundamental trend following portfolios;
- Quality stocks (about 60 to 80% investment)
- Special growth and innovation leaders
- Covered-call options and cash-secured puts
Quality Stock in Special Growth & Innovation Leaders as Portfolio Core
We invest about 40% in growth stock and innovation leaders, which are usually also the industry leaders with exceptional growth (super stocks).
Why are they called super stocks?
Because these are usually stepping into new revenue and profit venues.
For instance, you could include Apple and Google in this group.
Also Microsoft in its early days was a good fit, while Isra Vision currently fits the bill.
Covered-Call Options and Cash-Secured Puts
We use conservative option strategies to stabilize portfolios and adequately utilize cash and equity holdings.
Collecting premiums allows us to generate steady cash flows and less volatile deposits.
Which is why we go beyond the classic buy-and-hold approach.
We select companies through a computational-math based screening process, which ranks them based on liquidity and volatility.
Then, we invest in such companies using covered-calls and earn premiums on portfolios.
In which Stocks/Sectors do we Invest?
We invest in quality stocks, special growth and innovation leaders, which are present across all industries and countries.
We weigh the portfolio according to the fundamental valuation, price pattern and trading strategy.
How we build and maintain Positions?
SAMT AG monitors positions according to the market - depending on the situation we might even move 100% into liquidity.
For instance, we would look at market valuation and expected returns by considering the total market capitalization and the ratio of total gross domestic product (GDP).
What specific risks does the Portfolio contain?
Rule-based investing in quality stocks might limit the investor to a handful of equities.
Capital concentration can be as low as 4-6 values and may differ from the usual portfolio structure by up to 20 stocks.
This eventually leads to the risk of lumps or clusters.
However, similar to the general risk of stocks even the quality stocks face turbulence due to unexpected news.
For instance, a great company - whose share the investor holds - loses a lawsuit.
Established companies with impressive growth rates and earnings growth are not immune to market crashes.
The tremors of the housing bubble did not spare established companies.
Also, an overall economic downturn can affect even the best companies.
There is no absolute immunity, ‘decoupling’ can only help to a certain degree.
When an unpredictable event triggers a huge loss, this affects the entire portfolio.
However, with SAMT’s modular system, you can achieve optimal portfolio diversification at lower risk by including assets that have low correlation with each other.