Guides, Resources & Education

A Guide To Value Investing For Novice Investors

A full walkthrough and introduction to value investing for beginners.

Introduction

Value investors believe that markets are inefficient. In other words, the market prices of stocks fluctuate around their fair/intrinsic value because investors overreact to positive and negative developments for companies. This creates the opportunity to profit from purchasing stocks that are temporarily out of favour or in a dire state, in the hope that they will return to their true value with time. Another tenet of value investing is that purchasing stocks for less than they are truly worth i.e., ‘for cents on the Dollar’, means that a margin of safety exists where the upside (stock price appreciation) is proportionally higher than the downside (price depreciation). Value investing was pioneered by Benjamin Graham, who purchased stocks trading for less than their liquidation value (their remaining worth in the case of bankruptcy, should all debts be paid). Graham’s mentees include none other than Warren Buffett, who is arguably the world’s greatest investor. Value investing is driven by fundamental analysis, which looks at company-specific factors such as revenue, earnings, assets, and liabilities. Technical analysis, which explores statistical signals produced by trading activity of the stock in question is ignored in its entirety. Fundamental analysis looks at both qualitative (e.g. patents, quality of management) and quantitative factors (e.g. valuation, profitability, growth).

“Price is what you pay. Value is what you get.”

Warren Buffett, Chairman of Berkshire Hathaway

A few important notes:

  • This guide is suitable for individuals of any experience who want to learn how to pick stocks using a value investing approach
  • There is no shortcut – to become a proficient value investor, you need to dedicate time and effort to learning the principles
  • You will make mistakes when you go from theory to practical application (this is to be expected), so make sure you learn from them
  • When conducting fundamental analysis, assign the most weight to the numbers, and use qualitative factors to augment your research
  • Go to Investopedia to clear up any jargon that you may encounter
Foundations

Here’s a great ‘all-you-need-to-know’ introductory video to finance and investing by Bill Ackman – a multi-billionaire activist investor who founded Pershing Square Capital Management (a hedge fund). The video should establish some basic principles. Next, in my experience, I think it is best to start off by reading beginner-friendly, succinct books written by world class investors, namely Joel Greenblatt and Peter Lynch. The lessons conveyed in these books are invaluable and presented in a digestible manner.

  • ‘The Little Book That Still Beats The Market’ by Joel Greenblatt
    • Simply outlines the basic theory behind value investing
    • ‘Magic Formula’ experiment conveys that a simple application of value investing principles can produce outsized returns
    • Joel Greenblatt is a renowned value investor with an excellent track record
  • ‘One Up on Wall Street: How To Use What You Already Know To Make Money In The Market’ by Peter Lynch & John Rothschild
    • Peter Lynch is one of the most successful mutual fund managers ever; during his tenure at the head of Fidelity’s Magellan fund, he produced a 29.2% annualised return (more than double that of the market during the same period)
    • Lynch examines why non-professional investors have ‘an edge’ over Wall Street professionals in an inspiring and conversational manner
  • ‘Beating The Street’ by Peter Lynch & John Rothschild
    • An extension of ‘One Up On Wall Street’, this book details Lynch’s stock-picking approach, step-by-step
    • Examples are given of actual investments and what drove Lynch to purchase these stocks
    • Bridges the gap between theory and practice
Discovering Stocks

So how do you actually go about finding stocks? As Lynch recommends, you could simply keep your eyes peeled. Think about your favourite products and those of your family and friends. Then Google the companies behind them and see if they’re public and could make for appealing investments. Otherwise, you can use a stock screener to produce a list of stocks that fit certain criteria like earnings growth, or a low price-to-free-cash flow multiple. Here’s two free stock screeners:

Accounting

Needless to say, to make an informed investment decision, you need to be able to read financial statements. This means that you need to understand basic accounting. I’ve written three articles on how to analyse a U.S. company’s income statement, balance sheet, and cash flow statement. Pair these articles with the following short-series of videos produced by Aswath Damodaran, who is a lecturer in corporate finance and valuation at NYU’s Stern School of Business. Accounting is not rocket science – it just requires simple math and an eye for detail.

Source: Aswath Damodaran, YouTube
Sourcing Reports And Filings

To analyse financial statements, which are always provided annually (plus either semi-annual or quarterly reports), you need to obtain them first. For most public companies, you can simply type the name of the company plus ‘investor relations’ (IR) into Google. The results should lead you to the IR section of that company’s website, where you should be able to find an archive of financial reports. Alternatively, you can go to the relevant financial regulator’s or exchange’s website and locate a company’s filings there. See the list below:

Valuation

Valuation is about determining the current or projected worth of a company. If you don’t know how to value a company, how do you decide whether it is undervalued? There are three general approaches to valuing a company: relative valuation, which involves comparing similar companies; intrinsic valuation, in which value is determined based on a company’s projected future cash flows; and option-pricing models, where investors try to determine the worth of cash flows that could be ‘unlocked’ by a certain development such as a a biotechnology company’s drug candidate being approved. Relative valuation is the most objective and straightforward of these methods, so I’d recommend exploring this first. Intrinsic valuation should be explored next. It’s a more complicated method that is based on subjective assumptions (forecasting cash flows, risk-free rates, equity risk premiums, etc.). You can ignore option-pricing models at this point. Just make sure you use both relative and intrinsic valuation to judge the value of stocks.

Below, I have embedded a playlist of videos by Damodaran on relative valuation and multiples.

Source: Aswath Damodaran, YouTube

Next, here is a playlist which compiles Damodaran’s videos on intrinsic valuation.

Source: Aswath Damodaran, YouTube

Regarding intrinsic valuation, although I think Damodaran does a good job of explaining the theory, the application aspect is neglected. The video below is excellent in demonstrating how an intrinsic valuation works in practice.

Source: Learn To Invest, YouTube
The Psychology Factor

At its core, investing is a complex cognitive exercise which involves making decisions under uncertainty. Frankly, we are not good at this. I wrote an article on some of the most common psychological errors and biases that we face when investing, which should drive home the fact that our psychology can often limit our investing success. Don’t make the mistake of scrolling past this section! It could make the difference between growing and losing your savings. I have found that the best way to prevent your psychology from ruling you is to thoroughly understand it and its manifestations. I would suggest reading the following books:

Final Considerations
  • Making money in the stock market is about one thing only: identifying and exploiting mispricings
  • Stock-picking is probability-based – in essence, when purchasing what you believe to be an undervalued stock, you’re making a calculated bet that the price will appreciate in the future (return to fair value or beyond) based on the information that is available to you, so it pays to conduct thorough due diligence (assess a company’s prospects) using high-quality information
  • More is not always better when it comes to due diligence – there is a point at which the value of further research drops off as extra factors bear little or no relevance to the investment decision
  • Patience is key – your thesis needs time to play out, don’t sell until it does
  • Adopt a growth mindset – know that this is a complex game and seize learning opportunities
  • Investing is part science, part art – maintain an objective view and don’t assign too much weight to any one factor

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Johan Lunau – 17/07/21

2 comments on “A Guide To Value Investing For Novice Investors

  1. As a newbie to value investing, I appreciate you taking the time to provide this write up and resources. I’m curious as to why you left off The Intelligent Investor by Benjamin Graham from your list of recommended books? Being new to stock market investing and working to build a strong foundation, I have found the book to be an incredible resource and tool. I admit, it is the first book I’ve read on investing so the others you recommend might be more applicable to your goals of the article. Please know, I’m not knocking your article at all, I was just surprised it wasn’t included and curious as to why.

    Best regards,
    Steve

    Like

  2. Anonymous

    Hi Steve, glad I could help. I left off the II here because it felt too advanced for a beginner’s guide (it requires basic accounting and finance knowledge). But if you go to the resources page, you will find it.

    Like

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