Value investing – Do you know the ins and outs?

5 min read  
Date: 08 March 2017

Are you a value investor?

Identifying your strengths and an investment approach that works for you is a very important part of being a successful investor. 

Many investors may be familiar with value investing, but it does come with pitfalls, just like investing in shares generally. What are they and how can you avoid some of the common mistakes? 

Value investing involves looking for good-quality, easy-to-understand businesses that for one reason or another, are not highly valued in the market. 

According to Forager Funds Management Chief Investment Officer Steve Johnson, while investors may believe they understand investing generally, value investing places a heavy emphasis on future cashflow considerations. 

“Most people are out there trying to buy share prices that they think are going to go up,” he said. We are trying to buy shares in businesses where we think that business is going to pay us a cashflow stream over time.” 

Speaking at the Netwealth webinar titled ‘Successful value investing in small and mid-cap stocks’, Johnson said value investing is when you are trying to find stocks that are unloved and underappreciated but where there is an insight that makes you believe there is more cashflow in the business. 

A classic pitfall in investing generally is thinking a good story, trend or theme is necessarily a good stock or investment idea. 

“I see it all of the time and I see people lose a lot of money very frequently by buying into a narrative rather than buying the value of the business,” said Johnson. “We've seen the China growth stories over the past couple of years be very, very popular. We've seen baby food, we've seen retirement living in the lead-up to the financial crisis and this concept of an ageing population.” 

This is a very dangerous pitfall because investors don’t apply a price to the narrative. They are not asking themselves how much they are paying for the story and is that sensible? 

Another pitfall of value investing is overly optimistic growth projections. 

“I think it makes a lot of sense to sit down and say, okay, this company is valued at X million or hundreds of millions of dollars,” said Johnson.  “How big is the market that it operates in? How many limitations are there on what sort of market share this particular business can take?” 

Cultural differences are also a challenge for international value investors. A case in point, Forager Funds Management had owned a hardware store business in Germany for a period of time. Johnson said it has been an okay investment for them, but not spectacular. 

“Because Bunnings has been such a wonderful business in Australia, people automatically assume that hardware is a great business and that it's going to be a great business elsewhere. The market dynamics can be very, very different in different parts of the world.” 

Johnson suggests some of the common mistakes of value investors include: 

  1. An over-reliance on asset backings. A businesses valuation is cash that comes out of a business, not the assets that are sitting on its balance sheets.
  2. An over-reliance on low earnings multiples. A lot of value investors think eight times earnings is cheap for a stock and 20 times earnings is expensive. Twenty times can be cheap for a business that is going to grow and eight times can be very expensive for a business that's going to shrink.
  3. Forgetting it’s what comes out of a business that matter. If you've identified an asset or identified a valuable business but that company is not paying dividends and the management team is reinvesting the earnings, then understanding what sort of returns that reinvestment is going to generate is going to be crucial and fundamental to your overall returns.
  4. The impact of currency on international stocks. “It's very easy to have the good returns from a stock that you own undone by currency in global market,” said Johnson.

 

To hear the full presentation, ‘Successful value investing in small and mid-cap stocks’ click here or if you would like to speak to a member of the Netwealth team please contact us.