Value investing is the selection of stocks that trade for less than their true value, or in finance parlance, intrinsic value. In other words, value investors buy stocks that are currently undervalued, believing that in the long term, the prices of stocks would adjust such that it corresponds with the company's fundamentals.
Sounds hard to understand? I would like to illustrate this using an example of my favorite shirt brand: Armani Exchange (AX).
Disclaimer: All prices of AX products are fictitious and are just meant for illustration purposes.
Say I want to get this cool T-shirt (and seriously, it looks freaking cool), if I were to go to an AX outlet on a random day, the price of this shirt would easily cost you $200. You will be quite stupid to buy it then. As a "value investor", you would wait for the right opportunity to get it for less. For example, AX holds an annual sale during Chinese New Year, whereby all its products would be 50% discounted. It is then probably the right time to get it for half its price. In extreme cases, you would not even be satisfied with such discount. You would wait for a clearance sale which gives discounts up to 70%, and at that time you would get your dream shirt for just $60.
Apply this idea to stocks and you have value investing, plain and simple. Any time you buy a stock, you want the market price to be lower than its intrinsic value. You've made yourself some gain already by purchasing the stock at a lower price!
Some famous value investors are as follows:
Warren Buffet
Benjamin Graham
Seth Klarman
Walter Schloss
Irving Kahn
Why are stocks undervalued in the first place?
Irrational decisions by investors
Humans are just being humans; People invest irrationally based on psychological biases rather than analysis of market fundamentals. They buy when the price of a particular stock is rising or when the value of the market as a whole appears to be rising. Such a phenomenon is known as the "bandwagon effect", whereby people do certain things simply because other people are doing them, regardless of their own beliefs. In this case, people simply buy a particular stock because others are doing so, or at least the prices of the stock are showing as such (bullish trend).
A random picture of a bandwagon. LOL
Even the most professional investors tend to make the most irrational decisions, especially when the price of a particular stock is decreasing or when the value of the market as a whole appears to be declining.
Afraid of the idea of potentially losing their entire wealth, they accept a certain loss by selling at ridiculously low prices instead of keeping their losses on paper and waiting for market reversals. They have neglected the company's fundamentals in order to mitigate their losses. Rather than trusting in the company's fundamentals and believing that the company can pull through turbulent times, they succumb to their fear, and when the market's vicissitudes come to an end, that particular stock that he just sold increase in price, and all that the poor investor can do is to sit down and hate himself.
Other reasons
Of course there are other reasons why stocks can be undervalued. Sometimes stocks are simply "hidden" in the stock market; they are not featured in the headlines or are simply not glamorous at all. They often go unnoticed, and it is the job of a value investor to identify these stocks.
Occasionally, a company may not be performing too well, or even suffer from losses. However, just because a company experiences one negative event doesn't mean that the company isn't still fundamentally valuable or that its stock won't bounce back. Many investors forget this important concept, and often in their panic, they sell the stock in order to quickly get rid of it.
Conclusion:
I hope through this chapter I have given you a clearer picture of what value investing is all about, and how stocks become undervalued. In subsequent posts, I will be establishing the key rules of value investing or rather investment in general (which would be reinforced over and over again) as well as discussing on some value investing strategies.
Have a good day ahead.
Acknowledgements:
Investopedia has been a great guide to me, and it is through this website that I've picked up value investing. For this post, content is mainly obtained and paraphrased from investopedia. (I can't really introduce any new content in this post.) However, for subsequent discussions, additional research is necessary - ie. the golden rules of investment, early financial history, investment vs trading etc. Sources will be quoted in each post so as to avoid accusations of plagarism.
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