Value investing is an extremely rational investment method that focuses on sound economic principles. When you invest as a value investor, you invest for good, reliable reasons; not short-term trending or wildly optimistic speculation. You invest in companies that are good at producing wealth, not indexes or sectors.
Think about cultural memes associated with the stock market. What comes to mind? Risky. “It’s a gamble.” “I got lucky with that stock.” “Should I bet on stocks or stick with a CD?” Hell, with dumb-ass companies like Bear Stearns and Enron, and dumber-assed financial managers blindly putting together the average person’s portfolio, this is no surprise.
In my view, value investing makes investing a lot less like gambling by emphasizing the factors that make investing rational.
There are many investors who don’t understand why stock investing works, and given the fluctuations in the market, it’s understandable that stock investing might be perceived as a crap shoot. Some companies do well, some companies go to hell. On some days the market acts as if all companies are doing well, and other days it acts as if all companies are doing poorly. One year a company is gold, the next year a company is junk. What gives?
Value investing is the art (or science if you prefer) of buying high-quality companies at bargain prices. Value investors don’t invest in wide-indexes or focus on sectors. They focus on companies that do a good job at producing wealth.
Value investing works because the market is not purely rational, thus offering pockets of opportunity for the keen observer of economic fundamentals. Since the market involves emotion-driven, crowd following human beings who often buy or sell for irrational or poor reasons, the investor who focuses on business fundamentals is able to perform emotional arbitrage, selling when the market is irrationally exuberant, buying when the market is either irrationally pessimistic (or simply ignorant).
Now, let me be clear about something. A value investor does not invest in market trends. He or she invests in individual companies with solid fundamentals. A common metric that is employed for determining a good value investment is low P/E and high ROE. Low “price to earnings” ratio tells you that the market is ignoring this company for some reason (could be a blind eye, could be intentional -> it pays to find out why). High Return on Equity tells you that the company does a good job of using it’s investor’s equity to generate more money.
Now, I’ve gotten stung a few times by using the simple value investing algorithm of buying cheap (low P/E) but strong (high ROE) companies. The fact of the matter is that neither of these metrics are strong indicators of what the future holds. Will the market eventually correct it’s pricing to properly reflect the company’s value? There’s no guarantee that it will. Will the company continue to be good stewards of its shareholder equity? Again, there’s no guarantee that it will.
In addition to buying stock in cheap, wealth-producing companies you should put heavy emphasis on A) management quality and B) market share growth trending. If a company has a strong, realistic vision for the future, is gaining market share and is using its assets wisely (return on equity) then it is poised to continue producing wealth.
Now, if Wall Street is caught up in the latest sector fad, while ignoring this great company, it’s time to jump in and get a bargain. Jump on the wealth producing train, so to speak.
Or let’s say that you’ve identified this solid company but it’s situated in a sector that’s being hammered by Wall Street. The value investor says “Great! Time to get a bargain on a fabulous company.”
Stock investing works because the economy is not a zero sum game. Good companies use their resources and leverage to produce more wealth. The investor gets to share in this sum-gain in wealth. For this reason, investing is not about luck. It’s about intelligently and rationally choosing the companies that are best poised to produce more wealth. The value investor takes this a step further and tries to find such companies at a discount before the crowd rushes in.
