Image source: Getty Images.
"All intelligent investing is value investing." -- Charlie Munger
If you know anything about value investing, you probably know that many of the world's most successful investors practice it. The quotation above, for example, is from superinvestor Warren Buffett's business partner Charlie Munger. Value investing involves seeking investments that are available for less than they're worth. Being a profitable value investor is easier said than done, though, because it requires plenty of discipline. Here are some value investing tips to keep in mind as you go about it.
1. Keep your emotions in check.
Emotions very often work against us in investing -- especially fear and greed. Greedy investors will often pile into companies they don't know enough about simply because the stocks have been surging. They may buy stocks with little regard for the price, too, which can be a terrible move if the stocks are overvalued and likely to retract. Fear, meanwhile, often keeps us on the sidelines, or has us bailing out of good stocks simply because they've hit a temporary rough patch. Fear can make us avoid the companies that others avoid -- when they're often the ones with the most growth potential.
Boring stocks can be big winners. Image source: Pixabay.
2. Don't be afraid of boring stocks.
We're naturally drawn to with exciting stories and possibilities because they're...well, exciting. It's easy to want to turn your back on garbage-hauling companies, railcar manufacturers, flooring specialists, and companies that profit by selling breakfast cereals, bleach, or napkins. Still, many times those will turn out to be far better performers for you. When I recently screened for large-cap stocks that gained 50% or more over the past year, the results unsurprisingly included Amazon.com and videogame specialist Activision Blizzard, but also water services company American Water Works and retailer Ulta Salon Cosmetics & Fragrance.
3. Don't take the growth vs. value distinction too seriously.
As you read and learn more about investing, you'll frequently run across an apparent dichotomy: growth stocks vs. value stocks. Don't believe that they're so opposite. Yes, companies that are growing rapidly and that might be overvalued now are growth stocks. And yes, companies with stocks selling for less than they seem to be worth are value stocks. That doesn't mean that a stock can't be both undervalued and belong to a briskly growing company, though -- and that's a wonderful kind of stock to find. Some see Priceline as such a stock, with its last quarter featuring year-over-year gross bookings and earnings up 21% and 17%, respectively, and its P/E ratio merely in the mid-20s.
4. Do take the investor vs. speculator distinction seriously.
Meanwhile, it's underappreciated how different some investors can be. If you're chasing high-flying stocks and quickly snapping up penny stocks with exciting stories, or you're frantically jumping in and out of stocks each day without ever learning much about them, you're not investing. You're speculating -- gambling, really. The most successful investors tend to know their investments well, understanding the companies' competitive advantages and risks and exactly how they make money. They understand that when they buy into great companies, they become part-owners in them.
Healthy, undervalued stocks are likely to grow. Image source: Getty Images.
5. Get a rough sense of valuation from a P/E ratio, but look beyond it, too.
The price-to-earnings (P/E) ratio is a commonly used metric to determine a stock's valuation -- but don't rely on it too heavily. It's easily calculated by dividing a company's current stock price by its trailing-12-month earnings per share (EPS), and the lower the ratio, the more of a bargain the stock will seem to be. But the P/E ratio is flawed, as it doesn't let you easily compare companies across industries. Slow-growing, capital-intensive industries such as auto manufacturing will tend to sport low average P/Es -- often in the single digits -- while faster-growing industries such as software and biotechnology often feature relatively steep P/Es in the 30s or higher. Keep in mind, too, that a P/E ratio depends heavily on a company's EPS, which can be manipulated (legally or illegally) by the company. If a company buys back many shares, for example, its share count will fall, boosting its EPS -- and, therefore, depressing its P/E ratio. It doesn't account for the quality of earnings, either. A company generating earnings by selling lots of widgets is preferable to one generating them by selling off closed factories. Go ahead and look at a company's P/E ratio, and perhaps compare it with its average P/E over the past few years. But look at other measures, too, to get a more well-rounded perspective.
6. Be contrarian.
A smart way to find promising stocks is to look where others are not looking. Avoid the herd, which will be investing in market darlings, sending those stock prices up. Look for out-of-favor stocks, instead. Whirlpool, for example, has been beaten down due to weakness in China and the strong dollar depressing its prodigious foreign earnings, but those are just temporary problems. Power-management specialist Eaton has shed value over the past two years as it has lowered its performance estimates in the face of weakness in the industrial sector, but that won't last forever, and it recently offered a 3.7% dividend yield.
Consider any investment's risks carefully. Image source: Flickr user Paul Cross.
7. Be skeptical.
Look for undervalued stocks, but remember that many are undervalued for a reason. Fitbit might look enticing, for instance, with its stock more than halved over the past year, a forward-looking P/E ratio (one based on the coming year's EPS instead of the past year's EPS) near 11, and rapid revenue growth. This may indeed be a great buying opportunity, but only after you've considered its competition and are reasonably confident it will be OK. There are plenty of health-focused wearables these days, and even Apple, with its extremely deep pockets, is in the mix. At a minimum this will put pressure on Fitbit and perhaps push prices down, and at worst, it could mean eventual shrinkage of the company.
There are many other tips to keep in mind as you develop into a savvier value investor. For example, prepare to be patient while your investments appreciate, eventually approaching their intrinsic value. Keep up with your investments, too, as a compelling opportunity may grow less compelling over time if its competitive landscape changes, or its financial statements start deteriorating.
The most important tip is this: Keep reading, thinking, and learning. The more you know, the better your portfolio will likely grow for you.
