What is Value Investing and How Does it Work?

First, I guess I should define value investing.  The best thing I can really do is to let you know from the beginning that I believe that being a value investor is much more of an investment style than it is an adherence to any one set of strict criteria.

That being said, there are some basics tenets that are universally agreed to in regards to value investing.

The best description I've seen as a “definition” comes from the Finanical Times:

It really is a style of investing that was developed in the early 1930s at Columbia University by Benjamin Graham(financial strategist), a mentor to Warren Buffett , who showed an approach to find and buy stocks at a discount to their intrinsic value, namely to buy stock on sale, or to buy stocks for 50 cents that are worth $1.

Value InvestingValue Investing Basics

The most crucial component to value investing is the completion of fundamental research, as it's really the only way you can be sure that you have evaluated a company exhaustively enough to determine if its share price can be considered a “value”.

A company must have sound financials, their financial statements must be clean, not bloated with debt and perhaps most importantly– the company needs to have as Warren Buffet often says, “A durable competitive advantage”.

The type of research necessary to discover all of this information will no doubt require you to sift through annual reports, 10-k filings, and know how a particular company stacks up against their competition within their own industry.  Alternatively, you can pay for this sort of research and save yourself loads of time.

Then after you've finished all that digging and you've uncovered the company you think fits the bill as a top notch stock to invest your money in, you have to decide whether the current price of the shares are trading at a sharp enough discount to make it a true “value”. In the end, if the company's price per share is not trading at a significant discount, it doesn't make sound financial sense to buy the stock.

If you were to invest in a company who's stock price is trading at a premium, you would be forsaking the basic premise of value investing.

In this case, the market has already “baked in” the potential growth to the price of the stock.

You are in search of the stock that the market has yet to discover as being under-priced, you are in search of the anomalies.

Pretty simple…right?

Well, maybe not simple but it does take a bit of a common sense approach.

Filter the Companies

Becoming a skilled value investor takes patience and careful selection. You have to create an initial filter to cast out the companies that will not be a great match as value investments.

This filter should include the sifting of those companies that have an ROE (reurn on equity) lower than ten percent, alarmingly high debt to equity ratios, the exclusion of micro cap stocks (companies that have a market capitalization of $300 million or less), removing those companies without earnings and those who lack consistently positive free cash flow.

An Abundance of Resources

One of the greatest things about value investing is that there has been much information published on the subject from people such as Benjamin Graham, Warren Buffett, Joel Greenblatt, and Peter Lynch to name a few names most people will know.

Additionally, there are also some really great screeners you can find online that will help you at least narrow down the universe of stocks that fit the value investing criteria.


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