Of the many different investing strategies that a modern-day investor has to choose from, value investing is among the most tried and true of them all.
It is the foundation of Rule #1 investing because, when used appropriately, it can be one of the best ways to ensure success in the stock market.
Let’s dive into what value investing is, how it works, who uses it (hint: some of the most successful investors in the world), and how you too can use its principles to dramatically grow your wealth over time.
What is Value Investing?
Value investing is a strategy that focuses on investing in individual stocks, but not just any stocks, stocks in wonderful companies that are priced well below their value.
Value investing aims to reduce risk by increasing understanding of what you’re investing in in order to make wiser investment decisions, and purchasing it at a price that gives you a margin of safety.
It was first pioneered by Benjamin Graham, investor and author of The Intelligent Investor.
Another fun fact about Ben Graham is that he was Warren Buffett’s mentor and teacher. That’s right, the most successful investor in the world was taught by the guy who invented value investing.
According to Graham, a company’s stock was only undervalued – and therefore only worth investing in – if it could be bought for below its liquidation value. The liquidation value of a company is determined by its net assets per share.
The underlying principles of this timeless approach still persist to this day, and it remains a highly effective investment strategy, however, many modern value investors have made tweaks to Graham’s original theory.
The Theory Behind Value Investing
For Ben Graham, value investing meant finding companies that were undervalued and waiting until the market bid them up to their true value.
By the time Warren Buffett started investing money, though, the economy had changed, and finding deeply undervalued companies was not as easy as it had been in Graham’s time.
So what happened?
To adapt, Buffett adjusted the theory slightly, choosing to focus not only on finding companies that were undervalued but also on investing in companies that are what you might call “wonderful companies” with a high potential for growth.
For Buffett and the investors that followed him, it wasn’t enough for a company to just be undervalued. Instead, the best companies to invest in were ones that were both undervalued AND wonderful companies.
The Rule #1 strategy draws from this evolution of the classic approach to value investing to focus on quality companies.
This view of value investing dictates that the best way to make large returns on your investments is to find individual companies that are intrinsically wonderful, ran by good people and priced much lower than their actual value. A stock that hits all of these marks is what constitutes a value stock.
What are Value Stocks?
At its core, a value stock is a stock that is priced lower than its intrinsic value.
Intrinsic value is a term you’ll hear thrown around a lot when it comes to value investing. And that’s because it’s incredibly important. Value investors make decisions based not on a news article or another investor’s actions, but on the intrinsic value of a company, or what it’s actually worth, not to be confused with its sticker price.
For any investor, it’s critical to know that the sticker price you see doesn’t always equal the true value of a company.
Just because a company is “cheap” doesn’t make it a value stock, though. The companies themselves have to have a well-established history and show great potential for growth over time. This is why a deep understanding of the companies you invest in is foundational to value investing.
We Rule #1 investors define a value stock as stock in a wonderful company that is priced at 50% of its actual value. I’ll teach you how to identify wonderful companies and determine their intrinsic value a little later on.
The Value Investing Strategy
There are several key strategies within the realm of value investing that are worth considering.
At the root of all of them though are a few standard rules. Understanding these rules is an important step in learning the value investing strategy. While value investing may not appear to be all that complex on the surface, it can be a real challenge, but these tips will help you master it.
Don’t Fall Prey To Fear
The value investor is unlike other investors in that he or she isn’t swayed by the general public’s reaction. This is especially important to remember when fear comes into play.
Fear can make people sell too early or miss an opportunity to buy. But the value investor decides when to buy or sell based on a company’s intrinsic value, not based on fear in the stock market.
For the value investor, fear is a friend. Fear moves the market all the time, and if it isn’t justified, it could create excellent opportunities to buy stock in wonderful companies well below their value.
Focus on the Long-Term
Value investing is not a get-rich-quick scheme, it’s a buy-and-hold strategy. Once you manage to find a company that is priced lower than its actual value, it takes time for the market to correct and drive up the price of that company.
When operating as a value investor, you need to be patient and keep your focus on long-term profits.
Do Your Research
Successful value investors certainly do not pick stocks at random.
Instead, before investing in a stock, they thoroughly analyze it in order to determine its value investment potential.
True value investments require a bit of research. In order to have a deep understanding of the companies you are investing in, you have to get to know their fundamentals: how they operate, the pros and cons of their industry, their management, their financials, and more. But the more you know, the better decisions you’ll make and the better returns you’ll get.
Wait For The Right Time To Buy
When you analyze a company thoroughly, you may discover that it would make a wonderful investment but it’s not undervalued by the market… but that doesn’t mean it won’t become undervalued at some point.
A key component of value investing is buying stocks at the right time, and the right time will present itself if you’re patient.
Everyday stock market volatility and events such as recessions, market crashes, negative publicity, among others, create opportunities for value investors to jump in and buy when the price drops.
How To Identify Undervalued Companies
Learning how to identify companies that are undervalued is central to value investing.
But here’s the kicker:
This is a skill that takes a good deal of training, as the market doesn’t undervalue companies often and it certainly doesn’t make it obvious when it does.
Finding undervalued companies is not easy, which is why many people don’t take advantage of the value investing strategy, but with a bit of time and effort it can be done, and anyone—including you—can learn how to do it.
Use The 4 Ms
In addition to spotting undervalued companies, it’s also important to ensure that the companies you are investing in are high-quality enough to retain their value throughout the time that you are holding them. I like to evaluate whether or not a business is a quality company with what I call the 4 Ms of Investing: Meaning, Management, Moat, and Margin of Safety.
If you can check off each of these 4 Ms for a company you are considering investing in, it will be well worth your while.
The company should have meaning to you. This is important because if it has meaning to you, you understand what it does and how it works and will be more likely to do the research necessary to understand all elements of the business that affect its value.
The company needs to have solid management. Perform a background check on the leaders in charge of guiding the company, paying close attention to the integrity and success of their prior decisions to determine if they are good, solid leaders that will take the company in the right direction.
The company should have a moat. A moat is something that separates them from the competition and, thus, protects them. If a company has patented technology, control over the market, an impenetrable brand, or a product or service customers would never switch from, it has a moat.
Margin of Safety
In order to guarantee good returns, you must buy a company at a price that gives you a margin of safety. For Rule #1 investors, 50% is the margin of safety to look for. This provides a buffer that makes it possible to still experience gains even if problems arise. This is the final M, but arguably the most important.
These 4Ms draw heavily from the rules of value investing. Both sets of rules dictate that you must buy a company below its actual value in order to make a profit. That’s the bottom line.
Use Investment Calculators
As an investor living in the digital age, you have a lot of advantages that investors who came before you did not.
One of those advantages is access to software-based tools that are designed to help you determine the investment potential of a company.
On the Rule #1 website, we offer a number of free investment calculators to help you learn to crunch important investment numbers along your way.
If you need a little extra help determining whether or not a company is priced well below its value and is a good value investment, checking out these free tools is a great place to start.
Common Questions About Value Investing
As any smart investor would, you may have questions about value investing. I’ve answered a few of the most common questions about this strategy here to help you decide if it is right for you.
Can Value Investing Make You Rich?
When Warren Buffett first started investing, he used the associated value investing principles to grow a small initial investment into a large fortune, quickly.
In short, then, it is certainly safe to say that the strategy has the potential to make you a lot of money.
In fact, to this day, many of the world’s most successful investors could be classified as value investors in some form or another.
Are the Returns on Value Stocks Usually Good?
Returns in value investing are made whenever the market realizes that a company is undervalued and raises its stock price. This is one of the foundational principles of value investing: markets eventually correct undervalued stock prices to their intrinsic values.
So, investors who invest in value stocks when they are priced at 50% off their intrinsic value can stand to make a 50% return on their investment when the market ultimately corrects.
This may very well take some time (remember, value investing is a long-term strategy). It can even take several years from the time you purchase stock in a company you deem to be undervalued to the time it reaches its true value, but when it does, you can experience incredible returns.
So, if you do manage to find a company that is truly undervalued, the underlying logic dictates that the returns will come in time.
Bottom line: Value investing is long-term investing, but patience can pay off.
How Does Value Investing Compare to Other Investment Strategies?
Comparing and contrasting the advantages and disadvantages of value investing with other investment strategies can help you get a better understanding of what exactly it is and what it is not.
Some of the most popular investment strategies out there today include day trading, index investing and growth investing. Let’s discuss the key differences between these strategies and value investing.
Day Trading vs. Value Investing
Day trading has become a trendy option with investors because the big wins are publicized (not the big losses). The biggest difference between value investing and day trading is that the first focuses on the long-term while the latter focuses on the very short-term.
Day trading is also a lot more like gambling—betting on short-term fluctuations with high risk, whereas value investing focuses on minimizing risk by maximizing knowledge.
Index Investing vs. Value Investing
Investing in index funds is a popular option because it is arguably the most hands-off form of investing that there is and requires very little research.
However, it’s also a lot like gambling because you simply put your money in an index fund that tracks hundreds of companies traded on the stock market and cross your fingers, and hope that the market goes up.
With value investing, you are choosing individual companies to invest in and buy them at discounted prices rather than spreading your money out across the entire market.
Growth Investing vs. Value Investing
Growth investing is the practice of investing in companies that are growing at a rapid rate. There’s a common misconception that growth investing is totally different than value investing, but that’s a fallacy.
In reality, what is typically considered “growth stocks” can also be “value stocks” and you can invest in them as part of your value investing strategy. We don’t care about how quickly or slowly a company is growing. What we care about is that we are getting $10 of value for $5.
Value Investing Resources
As already mentioned, learning how to identify companies that the market has put on sale takes a little bit of knowledge and training.
Thankfully, there is no shortage of resources available that you can use to learn all about value investing strategies and principles.
Value Investing Books
A book on value investing is a great place to start.
A few of my favorites include:
- The Intelligent Investor by Ben Graham
- Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger by Peter D. Kaufman
- The Essays of Warren Buffett by Lawrence Cunningham
- The Dhando Investor by Mohnish Pabrai
- Security Analysis by Ben Graham and David Dodd
My daughter and I have also published 3 New York Times Best-Selling Books based on the principles of value investing.
If you’re looking for a book that will take you from knowing next to nothing about investing to becoming a successful investor in little time at all, these are great books to consider checking out.
Value Investing Podcast
Podcasts are another great, easily accessible, and digestible way to learn the art of value investing. Each week, my daughter and I host a value investing podcast called InvestED.
If you are looking for a way to learn all about key investing strategies while you’re in the car, working around the house, or at the gym, queuing up with this podcast is a great option to consider.
Value Investing Workshop
If you prefer a more hands-on approach to learning, then my Live Virtual Investing Workshop may be right for you.
This transformational workshop is designed to teach you everything you need to know to get started as a value investor in an enjoyable environment where you can ask questions and learn from the like-minded people around you.
Value Investing Webinar
For another virtual option, consider my free Investing webinar.
In this webinar, I go over some of the basic strategies used by the most successful investors in the world today. These strategies draw heavily from the concept of value investing, making this webinar a great way to get started learning the strategy of value investing.
On the surface, value investing doesn’t appear to be all that complex; it simply entails buying companies that are priced lower than their actual value. Managing to find these companies, though, can sometimes be a real challenge.
With these tips and tools, though, you can learn this proven investing strategy and become a more successful value investor.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.