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jueves, 17 de septiembre de 2015

The basic principles of Value Investing

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When we invest in the stock market there are lots of investment strategies and systems. However, among all of them there is one that has allowed investors to get great results: the value investing.

The value investing is an investment strategy which first developed the professor and investor Benjamin Graham back in 1928. The most famous disciple of Graham was the investor Warren Buffett, who following the principles of value investing has managed to become the third richest man in the world according to Forbes magazine and is considered one of the greatest investors of all time.  His investment vehicle is the holding Berkshire Hathaway, listed on the NYSE, so anyone could buy their shares.

In today's article we explain what are the basic principles by which the value investment is governed and how you can apply this strategy to an investment portfolio.

The value investing philosophy is the idea that financial markets are not always efficient. An efficient market is one in which all the information is collected immediately in the stock prices.

Followers of value investing believe that only long-term markets are efficient, and therefore in the long term the share price match its intrinsic value, which is no more than the value that a informed buyer will offer for the 100% of a company in a negotiation of equals.

In the short term, the market can be inefficient due to economic reasons and the price may not reflect the true value of the company (intrinsic value). Thus, in some cases we find that the price at which shares are traded is above the intrinsic value of the company (in this case we say that the company's shares are overvalued), or we may find that the market price of shares fall below their intrinsic value (we say that the company's shares are undervalued).

It is in this second case (undervaluation) where value investors focus on for deciding what stocks should be incorporated into a investment portfolio. When value investors seek candidates to be part of their portfolio, they focus on finding the most undervalued companies as possible, ie companies which have a market price well below their intrinsic value.

This difference between market price and intrinsic value is called the margin of safety.  The main value investors usually consider only companies with large safety margins, never less than 15-20%.

How value investors select stocks?

When selecting stocks that may form part of a value-style portfolio, the investors demand that these companies meet certain requirements to be taken into consideration:
  • They must have an easily understandable, simple business with growing cash flows. This was the key why Warren Buffet decided not to invest in technology stocks in the dotcom bubble which burst in the early century. Time proved him right.
  • The team managing the company should be of confidence with good management track record and generating value for shareholders.
  • They must be companies with a strong financial position, with debt levels under control.
If companies meet these requirements, then the value investors begin to calculate the intrinsic value of the company. To determine this value, they are based on the so-called fundamental analysis, whereby studying the financial statements of the company and determine a target price (intrinsic value) for the company in order to calculate the margin of safety.

In short, the investment value is defined by:
  • Investing with a long-term vision.
  • Apply fundamental analysis and dismiss the technical analysis.
  • Don´t pay to much attention to the macroeconomic analysis.
  • Rarely use derivatives (only for hedging against a falling market).
The retail investor who wants to carry out this successfull investment approach can study the financial statements of companies that consider interesting, although if the investor has neither the time nor knowledge of business valuation, one option is to buy shares of mutual funds based on value investing, whose stock selection is based on this philosophy.

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