What are the pro's and con's of value investing?

I answered a great question at TickerHound posted by the staff (as they do from time to time to stimulate discussion) that I thought I should simply repeat here:

What are the pro’s and con’s of value investing? Do you think it’s a worthwhile strategy or are you more of a “efficient market” proponent?

Well, I consider myself a Value Investor in everything that I do … stocks, real-estate, etc. The only exception is in the case of businesses, I’m generally a Growth Investor or a Value Investor.

Value Investing simply means “buying something worth $2 for $1” … well, not exactly, but you get my point: buying something for less than it is WORTH.

Now, this is a critical distinction: just because something was selling for $2 last week, and is selling for $1 this week, doesn’t mean that it is a VALUE Stock … it may only be ‘worth’ $0.50 and the market may simply be driving the price down to that … and, beyond!

In fact, that same stock (really ‘worth’ only $0.50) may BECOME a Value Stock if/when the market overshoots and sends the price down to $0.25.

The problem with Value Stocks is then one of KNOWING what they are truly worth at any point in time, and only buying when they are selling for a price less than that (preferably, with a large Margin of Safety … which simply means, buying it for MUCH LESS than what you THINK it is worth “just in case” …).

Now that we have covered the basics, what is the PRO of Value Investing?

Exactly that … being able to buy something ‘worth’ $2 for only $1. I can’t think of a better, more sure way of making money than that!

Then, what is the CON of value Investing … after all, there must be some or we’d ALL be doing it?

Simple: as I said before, it’s all about KNOWING which stock that is currently selling for $1 is actually worth $2 (and, avoiding the ones that are only worth $0.50!!). And, that takes some knowledge and skill. Warren Buffett has that knowledge and skill … so do many others, to a greater or lesser extent.

One other CON – one that is, ironically enough, addressed by another TickerHound question: “Is technical analysis still applicable in a “news driven” market like the one we’re in now?”:

If a stock that you KNOW is worth $2 is currently selling for $1, is it an automatic BUY?

Well NO … you see, you KNOW it is worth $2, but the rest of the market may not!

Or, it may have BEEN worth $2 but there is something happening (maybe a pending lawsuit around a key patent, or the loss of a major contract, or … ) that YOU don’t know about because it hasn’t hit the “news” (or TickerHound) yet, but those ‘in the know’ are selling off the stock by the truckload.

So, that’s where technical analysis is not just applicable in a “news driven” market like the one we’re in now, but absolutely CRITICAL for buying Value Stocks …

… it will tell you WHEN to buy (or sell off) that stock holding, based upon what the “insiders” are doing.

If you want to learn more about Value Investing, and using Technical Analysis to know when to get in/out of a Value position, I recommend picking up a copy of Phil Town’s excellent primer: Rule 1 Investing

… and, Good Luck!

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7 thoughts on “What are the pro's and con's of value investing?

  1. I think you’re dead on with this one. Value investing works as long has you have the resources to avoid the cons. Haven’t picked up Phil Town’s book yet but the site is pretty good, I think I might have to make a trip to the bookstore this weekend.

  2. @ Tap – If you like the book, send Phil a note letting him know who recommended it … I’m trying to get him as a ‘special advisor’ for our http://7m7y.com 7 Millionaires … In Training! project. AJC.

  3. One major con that it seems few people talk about is the relatively in depth knowledge of accounting needed to value invest successfully. Many people I have met claim to be value investors who don’t even know basic accounting or how to discount future cash flows, both of which are fundamental principles to value investing.

    Adrian it could be great if you could do a post on more of the specifics you look for as a value investor in either a stock or a business.

  4. @ Andrew – To DISCOUNT a future cashflow, you first have to be able to ESTIMATE a future cashflow 🙂 Anyhow, sounds like TWO posts to me …

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  6. I think the other thing that hasn’t been discussed is temperament/personality.

    My understanding of what I’ve read by Graham and others is that you have to be able to largely ignore the herd mentality of humans (which is a successful behaviour for surviving — though not for really prospering).

    You have to be able to watch have faith in your valuations. If, in the short term, the market tanks but the fundamentals don’t, you have to have the resolve not to panic sell (indeed, if the market tanks, your value stocks should be even more value, so you should buy even more of them). Likewise, if everyone is getting into “The Next Big Thing” (e.g. tech bubble) or the market is getting carried away with itself for no good reason generally, you have to at least avoid buying into that, and possibly even sell what you have if it’s going beyond its true value and look for new bargains instead. Of course, you may take a long-term hold approach too, which would also have its merits.

    There are plenty of really, really smart people out there who get undone by their emotions. I believe Isaac Newton is a classic example. Didn’t he buy into the South Sea Bubble early, make a ton of money, cash out, buy back in at a higher price, and do his shirt in the inevitable crash?

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