Everyday Financial Guide

January 9, 2012

What is Value Investing

Filed under: Investing — Tags: , , , , , — thefranksteak @ 11:31 am

Value investing is the belief that you should determine the intrinsic or actual value of an instrument before you purchase it. A value investor bases her stock picks on the value of the underlying assets and current profits rather than the potential profits.

The Market is Irrational

The basic ideas behind modern value investment were invented by legendary investors Benjamin Graham and David Dodd in the 1920s and 30s. The basic ideas are that the market is irrational and investors must perform a fundamental analysis of stocks.

Graham believed that the market rarely sets the correct values for stocks. Instead he taught that the market was completely irrational and usually overvalues or undervalues investments. He actually compared what he called “Mr. Market” to a madman in some of his books.

Therefore, investors should look at the company that issues a stock rather than the market price. Graham taught that investors should always read the prospectus and earnings statements and carefully evaluate the company before purchasing. Graham insisted that this would allow you to buy stocks at less than their real value because the market often undervalues good companies.

Fundamental Analysis

Graham laid his ideas out in the books The Intelligent Investor and Security Analysis (coauthored with Dodd). One of his most successful pupils is Warren Buffett. Buffett’s approach is to seek out undervalued companies and purchase them. Buffett’s approach is based on fundamental analysis.

A value investor looks at a company’s fundamentals before spending her money. She looks to see if the company is making or losing money, if it has a large amount of outstanding debt, if it has a large market and if it is generating cash. A value investor would favor a stable company with a proven product and large sales over a startup with huge potential.

That’s why Buffett bought Coca-Cola stock rather than technology stocks in the 1980s. Coke was selling a product and making money everyday, many of the tech companies did not make money for years.

Value investors focus on how an investment is performing right now rather than how much it could make in the future. They will not put money into companies that are not making money no matter what their potential is.

Graham’s Formula and the Margin of Safety

Another thing that a value investor will insist upon is the margin of safety. That is why they invest in companies with large cash reserves. Such firms will be less likely to borrow to cover costs or expenses. Value investors stay away from any company that has a lot of outstanding debt for the same reason.

Graham also devised a formula that most value investors use: he taught that a company’s true value is based upon intrinsic value and current earnings. Any decision to purchase a vehicle must be based up on its present value and the money it is making right now. Projections of future earnings must always be ignored when making investment decisions.

Value Investing and You

Value investing is a very good basic investment strategy with a proven track record. Unfortunately the investment industry is not very fond of it.

The reason for this is simple, value investors like to buy and hold. Brokerages and traders make their money on commissions on stock and other sales. They prefer it when people speculate or actively trade. They make money when you sell and you buy, not when an investment sits there.

Value investing would be an excellent strategy for somebody investing for retirement to follow. Picking out a few good safe investments and holding onto them is the best way to make and keep money. Unfortunately it is not exciting so both the financial media and the investment industry work to discourage this type of investing.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Calculator, Annuity Interest Rates, and Annuities Good or Bad.


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