Value Investing – Principle #2: Intrinsic Value (Lesson 7)

Intrinsic Value

Intrinsic value is just one of the four principles of value investing. Intrinsic value sets the floor price of the investment; i.e. it is an automatic buy. Any price higher than this intrinsic value must be substantiated by other value investing criteria. In effect, other criteria may increase the buy point upwards of 20%.

Intrinsic value utilizes one or more of three different valuation methods. The first method and customarily applicable to high quality stocks is the discounted future free cash flow formula. The second method works best with penny and small-cap stocks; this is the traditional book method. Mid-caps’ intrinsic value is best served by the net assets value method adjusted to fair market value of the underlying assets. Those companies with strong fixed asset positions in the mid-cap market capitalization range are best served by this particular method. In effect, the accuracy increases significantly with the net assets value adjusted by fair market values for the underlying fixed assets.

Value investors customarily use the discounted cash flows method; but here too, there are adjustments tied to certain criteria to provide a more accurate and reasonable intrinsic value for the stock.

Value Investing – Principle #1: Risk Reduction (Lesson 6)

Value Investing

With value investing, steps are taken to dramatically reduce potential financial losses. Risk associated with financial loss is addressed through three important practices. The first and best defense against losses are the type of stocks purchased. Only the best are considered with value investing. The first section below explains this in more detail and illustrates the different tiers of stock and why the lower tiers are ignored with value investing. The second best practice to reduce risk is a comprehensive understanding of the respective industry where value investors trade. The second section below goes into a comprehensive explaination of how knowledge of the industry is essential with reducing financial risk. The final best practice to defend against losses is a fundamental understanding of a company’s financial depth, the ability to withstand years of economic turmoil. The third section below introduces this mathematical algorithm for the reader. In addition, it introduces the first financial term of many that are used with value investing – book value. This term is used throughout value investing as a standard to compare other investments against and of course the ability of the particular investment to withstand long-term negative forces and quickly recover from any unusual events.

There are still many other practices and tools to reduce risk; they include understanding how operating cash flow must be positive, using business ratios to understand trends and finally, using key performance indicators to assess productivity.

Value Investing – Primary Tenet of Business (Lesson 5)

Value Investing

With the stock market, buying low and selling high is the goal for any investor. But the real problem, and it is depicted well in the illustration above, is knowing when the lows and highs exist. If you purchase the stock at its absolute lowest point in a cycle and then sold it at the highest point in the cycle, well you are either God or lucky. The simple truth is that nobody can predict either extreme. Value investors are not trying to predict either extreme; value investors only wish to identify acceptable lows (good value points) and reasonable highs to dispose of the investment. In effect, value investors merely take advantage of a good portion of this volatility with stock.

Value Investing – Holistic Approach (Lesson 4)

Value Investing

There are several underlying elements that make value investing so successful. Value investors cover all the respective elements no differently than how many people thoughtfully resolve problems. An holistic approach towards investing is utilized. This refers to to gaining an understanding of the respective industry and its members; i.e. understanding what makes the pool of investments work. Next, value investors identify key indicators of success and for comparison among the members of the pool of potential investments. Discovering why one member is so much more successful than others allows the value investor to gain perspective and use this to fully understand operations of all members of the pool of investments. With this knowledge, it is easy to develop a set of financial metrics that quantifies or ranks the respective members in the pool. This ranking is essential with establishing the respective buy/sell points. Finally, each member’s intrinsic value quantifies the overall desirability of the respective company. Now it is merely a process of enacting the model and allowing the model to do its job.

Value Investing – Market Fluctuations (Lesson 3)

Market Fluctuations

There is a hierarchy of forces that drive stock market fluctuations. Economic wide forces have the greatest impact overall. There are many different economic wide drivers of downward pressure or indicators of expansion. They include: 1) Federal Reserves’ interest rate adjustments that occur multiple times per year; 2) Acts of law by Congress; 3) Consumer spending; 4)Volume of credit; AND 5) Unemployment rate.

Sector and industry forces are the mid range forces that swing share prices in a direction. Sector and industry wide fluctuations are customarily driven by changes in law or regulations. Sometimes it is driven by consumer preferences.

Finally, company financial and performance indicators are the final forces that can affect market price and the fluctuations found with stock prices. Value investors seek significant market declines or returns to prior peak market price per share. Quarterly financial reports rarely move a stock’s price two to three percent per share in any direction. Value investors are looking for discounts of more than eight percent or increases back to prior peaks. It doesn’t mean the quarterly reported information can’t be the final nudge in that particular direction and often they will have enough impact on the share price to complete the minimum desired change.

Value investors must be acutely aware of these forces and how they impact the respective pools of stock value investors use to create their respective buy and sell models.

Value Investing – Risk Aversion (Lesson 2)

Value Investing

Value investing does require some volatility with the market in order to have opportunities to buy low and sell high. A static market, even one with level growth will not work with value investing. Fortunately, the market isn’t stable and volatility does exist. This volatility is driven by multiple forces: politics, interest rates, consumer patterns, environmental conditions and more. Thus, opportunity exists for value investors. However, value investors seek opportunity with minimum risk.

Investing in any financial instrument comes with risk. The absolute worse case is full economic chaos created by a meltdown of governmental authority. If this were to happen, it would not matter what kind of financial instrument an investor holds, all of them are worthless as you can’t eat paper. Some would say physical possession of gold is the only pure investment because it would be tradeable in case of world disaster. This would be true if there exists a government to enforce some resemblance of order allowing trade between producers and consumers.

Ignoring total breakdown, financial instruments do have a hierachy of risk associated with their potential to become worthless. Understanding risk aversion starts with understanding the spectrum of financial instruments and their inherent risk factors. In addition, this is further refined by size, i.e. market capitalization of the respective issuer of the financial instrument. Finally, risk aversion is also a function of the dynamic range of the respective company backing the financial instrument. The following sections provide this holistic thinking related to risk aversion, specifically as it relates to stock investments.

Value Investing – Reasonable Expectations (Lesson 1)

Value Investing

Value investing is superior to other investment models over long journeys of time. In the short run, volatility can paint a false picture of success for other methods of investing. Adherence to core principles and preset buy/sell points will win, not in large increments, but will prevail over extended time in years. The key is to have reasonable expectations from the results of an investor’s hard work. Don’t be mistaken, value investing does require some commitment by investors. An investor should be willing to invest one to two hours per work on their portfolio, most of this reviewing financials and implementing the buy/sell orders to the broker.

There are three reasonable outcomes a value investor expects. The first relates to actual returns on the investment, net of fees and taxes. Secondly, value investors will also experience less stress than other forms of investing. This is a reflection of setting up financial boundaries and simply allowing time to do its job. Finally, don’t kid yourself; this is not an easy program. It does require some work. A reasonable expectation is one to two hours per week for a portfolio less than $1 Million. Once you understand the system, it is relatively easy to methodically follow a regimen of checking resources and verifying compliance to the plan.