Warren Buffett’s Value Investing Strategy: In simple terms, value investing refers to the idea of buying stocks that trade at a discount to their intrinsic values (i.e., entering when they are cheaper than their true worth).
The concept of value investing was coined by Benjamin Graham and David Dodd. But how does one determine this? If the intrinsic value is lower than the current market price, then the stock is considered overvalued.
On the other hand, if the intrinsic value is higher than the prevailing market price, the stock is referred to as undervalued. This concept is based on the premise that every stock has an intrinsic value. Intrinsic value means a stock’s true worth.
With the help of incorporating fundamental analysis, it’s easy to determine the intrinsic value. Investors incorporate different methods to arrive at the intrinsic value of a stock. These methods include relative valuation, discounted cash flow method, etc.
The benefit of value investing is that stock price will eventually reach its intrinsic value over the long term. In the process, it makes a profit for an investor.
One thing that investors need to keep in mind is value investing always pays off in the long run. This is because that is when prices tend to arrive at intrinsic value. Value investing doesn’t predict what will be the price in 2 days or 2 months down the line.
Instead, the principle of value investing targets to pick undervalued businesses that should outperform in the long term. Let’s try exploring Warren Buffett’s Value Investing Strategy in the blog.
Despite being a successful strategy, it is believed that value investing is difficult to follow. Let’s find out the reasons behind the same.
- We have this notion in our mind that investing should always be done in the companies which perform well. There are several parameters to assess the performance of the company like revenue growth, profit growth, etc.
However, the companies which come upon value screens can be the ones not doing so well. Therefore, most people find it hard to go long on the stocks of these companies.
This is the first reason why people find it difficult to use value investing in the real world. If the principle of value investing focuses on buying below the intrinsic value, it’s quite certain that stock price would have fallen due to the changing market behavior.
People become reluctant to enter these kinds of stocks. What they forget is that the long-term fundamental position of the company has not changed because of a temporary downfall in the market.
- As explained earlier, value investing only works in the long term. The stock might not perform in one year, two years, or even in three years. People need to stick to that stock for these periods, and most people are not capable of doing that. This is the second reason why people find value investing difficult.
Even after applying this sound approach to investments, one should be ready for long periods where things might not turn in their favor or as expected. To succeed in value investing, one needs to have a strong conviction to withstand such periods.
Intrinsic value is based on the company’s fundamental factors including revenues, profits, cash flows, etc. The market prices tend to deviate from intrinsic values in the short term principally because market sentiments change.
Another aspect is that it is beneficial and important while use value investing is ensuring a margin of safety.
Why is Margin of Safety Important?
Source – Investopedia
The margin of safety helps protect an investor from mistakes. If some extraordinary assumptions were taken into consideration which led to overestimation of the intrinsic value, the margin of safety provides a cushion. Simply put, the higher the margin of safety, the better it is.
A lot of assumptions come into the picture when arriving at the intrinsic value of a particular stock. Therefore, the process of arriving at an intrinsic value is highly subjective. There are chances of making errors. Thus, the margin of safety provides a comfort level.
There is a central challenge to value investing. To outperform the crowd, you have to choose a different path and make contrarian bets. However, investing in such a manner means that you will certainly see some periods during which things won’t go as per your expectations.
But good research and patience definitely pay. That concludes the article “How To Follow Warren Buffett’s Value Investing Strategy.” Please share your thoughts in the comments section below.
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