Investment Styles 101: What is Value Investing?

What is value investing?

A few weeks ago, we had a live class about creating and managing investment portfolios in uncertain times.

During the class we discussed how our investment portfolios are influenced by our future needs and the vision we have for our lives.

We also spoke about this concept of generational wealth and wealth creation - the idea that we want to create wealth that outlasts our lifetime, so even our children don't have to worry about retirement.

There are many ways to do this.

Investing is one way but within the financial world, there are many schools of thoughts on how to get the best return on investment.

The school of thought I like is: Value Investing.

This is the school of thought that Warren Buffett subscribes to.

What makes you a value investor?

1. You buy undervalued stock

When you follow this style of investing, you invest in company stocks or equity (shares) and your focus is finding companies that are undervalued on the market so you can invest in them.

The mentality here is that you make your money when you buy a stock and not just when you sell.

You want to invest in companies that still have room to grow and that will continue to be profitable in the future.

You want to identify a share that's really been overlooked by the market - the only time you buy a share is because you believe it's worth a lot more.

So you buy a stock for US$20 on the stock market, only because you're sure it's worth US$40.

How do you know the true value of the share?

The value of anything is subjective, but you do your research. You research the industry, research all the companies operating in that industry and you look at the company's management team.

And you look at the company’s financial statements and look at profitability, cash reserves etc.

But...this is where value investors clash with Wall Street.

Wall Street brokers look at the numbers and the financial history of the company and then they make the decision to buy a company.

Value Investors like Warren Buffett use a lot of Emotional Intelligence when investing - they look at the numbers, but they also look at the character of the managers and the board of directors that run the company.

They believe that a company can only grow if management is trustworthy and a company that’s run on sound values by leaders with a clear vision, strategy and a plan to execute the strategy stands a great chance of remaining profitable in the long term.

2. Value investors also look at investing as a long term game

They believe in buying a stock forever, not even for 5 or 20 years but forever and that's why they need to understand the company's vision and leadership.

They don't sell during bad economic times. They only sell when the share becomes overvalued.

So imagine your $20 share skyrockets to $60. But you know it's only worth $40 on a good day. That's a good time to sell.

Your investment decisions are not dictated by the market's mood swings but by your own research and understanding.

In general, when times are bad, people freak out and are driven by emotion and sell all their investments in the stock market or in bonds.

If you're a value investor, bad news on how the market is doing, doesn’t impact you and neither does good news. You're basically an emotionally intelligent investor because you make financial decisions when calm.

Investing is a time game.

3. Research, research and understand what you invest in

Value investors like Warren Buffett, spend months just researching a company and an industry before making an investment decision.

When the Internet bubble happened and everyone was investing in every dot com company because it was new and hot, Warren Buffett wasn't interested - he invested in Coca Cola and Unilever and said they were entering the new millennium with these products because he couldn't understand the business model.

(I have been reading Warren Buffett's newsletters since I was 18 when I decided to study finance and economics).

Everyone said he'd lost his touch and when the bubble burst, many people lost their money.

He then invested in Amazon and IBM, because their business models were simple and easy to understand.

Value investors, invest in the things they understand and that make sense to them.

They believe in simple and easy to understand business models.

4. They focus on companies that are more concerned with profitability than share price

We live in a world where managers are rewarded, not for being profitable, but for increasing the share price.

Value investors, understand that share prices are influenced by PR and that depends on how the public feels about you at any point in time.

Companies grow through profitability and of course PR also influences profitability but a company that focuses on profits and company growth, already understands this so they’ll manage PR but also focus on building a good business to support that PR.

Basically, they want to invest in companies with a good foundation - financially and ethically.

Again - research is the key word here and as you can see, it's not just about the numbers.

5. Ethics

Value investors understand that companies that are built on bad ethical practices are PR disasters because eventually the truth comes to light.

And when that happens companies lose money, investors jump ship and shares lose money, which means you lose money as an investor.

So they do their research on how the company conducts business and if this will be a problem for them later.

They’re obsessed with investing in companies that are honest and open with shareholders.

As you can see this is very different from being a trader and trading shares or Forex.

Value investors aren’t thinking just about making money from market movements or even from an increase in the next few years; they are thinking about long term growth.

Personally I see myself moving into this style of investing when I start investing in individual shares on the stock market (currently I invest in EFTs instead of just individual shares).

For now, I just don't have the time to do this in depth research.

I leave you with a quote by Warren Buffett, "Rule number 1; Don't lose money. Rule number 2: Never forget rule number 1."

Let me know your thoughts in the comments section below.