As the bull market ages and becomes more volatile many investors are starting to hedge their bets. For some this simply means selling and holding on to cash for the time being. For others it has to do with re-balancing their investment portfolios. More and more we hear that it is time to switch over from a focus on growth and move to value investing. This is probably good advice but how do you do that? Today we consider what to look for in value investing.
Years ago we wrote about value investing for long term profits.
There is always a degree of market inefficiency due to lack of information, poor information, or market psychology. And the market eventually discovers the true value of any given stock as fundamental analysis comes to the fore. Investors who study the fundamentals to discover the intrinsic value of a stock and its margin of safety will tend to profit in the long term. But, what are the tools that one must use in value investing for long term profits?
Investors like Warren Buffett look for companies whose products and business plans are easy to understand. And they look for companies that are reliably going to be making money with those products and business plans 5 and 10 years in the future. Buffett famously explained that he did not know what a given tech product would be worth 5 years hence in a fast evolving tech world. But he did have a pretty good idea what a Snickers bar would be worth! Value investments have two characteristics, intrinsic value and margin of safety.
Look for a Margin of Safety in a Value Investment
Finding the margin of safety of a stock is the first thing to look for in value investing.
The most reliable margin of safety of a stock is money in the bank and no debt. Next is ownership of real estate, factories, and more unencumbered by mortgages. Years ago when Sears broke up it was essentially a penny stock until investors realized the value of its real estate holdings! The same has been true of railroads, steel mills, and companies in the oil and gas industry.
Apple is good case in point. When Steve Jobs came back to Apple he had to go hat in hand to Bill Gates to get a loan to keep Apple afloat. When the company made its comeback Jobs was adamant about Apple keeping a huge cash reserve in case of a rainy day. Periodically Apple buys back stock with its cash reserve but it still keeps a substantial amount of money on hand. The first thing to look for in value investing is a margin of safety.
Intrinsic Value in Investing
We often refer to our article about intrinsic stock value.
The dictionary definition of intrinsic stock value is its fundamental value. It is obtained by adding up predicted future income of a stock and subtracting current price. It can also be seen as actual value of an equity versus its book value or market value.
Read the article for the formula for calculating intrinsic value. Determining intrinsic value is being able to predict that people will be paying for Snickers bars in ten years at the same time that they will quit buying one tech product and switch to another.