Investing is more than the cat and mouse game portrayed by financial media and stock tickers floating above Times Square. A better approach ignores the ephemeral ups and downs of daily market movements. Instead, the passage of time can be used to an investor’s advantage, through the ownership of well run businesses purchased at reasonable prices and then held, often for several years. This is a more proven approach; this is value investing.
With origins dating back to the 1930s, this method has a proven track record of success when executed properly. Effective value investing requires equal parts patience and care. Rarely do value investors hold positions for less than three years, and the decision-making process leading up to a purchase requires years of observation and research diligence. Value investors aren’t in the business of “trading stocks,” but of building a portfolio of securities that will return capital to shareholders. An active trading strategy requires no more than a few dollars and an online brokerage account, while true value investing can only be accomplished through intimate knowledge of the companies and markets involved, and years of practice.
So how does one go about selecting only the best long-term investments?
To outperform broad-based equity indexes, a portfolio’s sector weightings cannot mirror the S&P 500. Simply put, where the broader markets zig, value investors zag. If the S&P 500 is heavily over weighted in the telecom, real estate or financial sectors, for example, value investors seek other sectors for value, especially those that are largely overlooked by the majority of investors.
Unloved and undervalued companies are a value investor’s dream. The “bones” of a target company must be intact, so an obvious first step is to examine the company’s balance sheet and income statement. The financial media tend to focus on price-to-book ratios, forward earnings projections and cash flow. Value investors look there as well, but these figures don’t paint a complete picture. Take a more holistic approach to the industry at large, comparing stocks to their peers, and look for potential market expansion and other, less-tangible factors. In short, value investors evaluate financial data within the proper context and seek out narratives that help tell a firm’s history, as well as where it might be going.
A typical holding may even be “distressed” in some way. But value investors don’t simply discard struggling businesses, especially if there’s a discernable path to recovery. Depressed valuations, whether due to negative headlines or lagging earnings, can signal opportunity in the eyes of value investors. The key is delving into a company’s fundamentals and identifying a plan to get back on track.
In this regard it’s important to focus on management. Has the management team been in the business for long? What’s their track record? Do they understand that they work for shareholders? Does the team have a history of delivering on their promises? Perhaps most important, how is management compensated? We know that over time people will do what they are paid to do, so incentives matter.
As noted above, day traders don’t have the luxury of patience. Value investors can use the calendar to their advantage by buying at low prices and waiting for a turnaround. But our patience is not unlimited. For every investment, a time comes when a choice must be made: sell or hold?
Normally a change in management from one that we know and trust to one we don’t is a sure-fire sell signal. Other times a change in basic strategy will cause us to exit a position. Occasionally, a stock is priced to perfection. But even when we sell, we often put the company “back in the hopper” and watch for future opportunities to buy it back at lower prices down the road.
For value investors, wealth management isn’t about charts, stock symbols and dollar signs. Instead, value investors view themselves as partners with the companies in which they invest. Building wealth isn’t about timing the market, but using time, expertise and patience as allies to create true long-term value.