If you've ever heard of Warren Buffett , you've likely encountered the concept of value investing. Buffett, often called the "Oracle of Omaha", has used value investing principles to build his company, Berkshire Hathaway, into one of the world's most successful holding companies.

Thanks to Warren Buffett, value investing is now favoured by investors across the world. While it differs from passive long-term investing, value investing remains popular among many Australian investors for its potential returns. Understanding this strategy will help give you a new tool to add to your investment arsenal. In this article, we’ll explore the principles of value investing, and how it can potentially help you build wealth over time.

What is value investing?

Firstly, what is value investing and how can everyday investors apply its principles for long-term investing?

Value investing is about finding hidden gems in the stock market. Imagine you're at a garage sale and you spot a rare antique selling for a fraction of its worth. You snap it up quickly, intending to hold onto it and hopefully resell it at a much higher value down the track. Value investors try to do the same with stocks, looking for companies they believe are undervalued by the market.

How it works

Value investors like Buffett spend a lot of time researching companies. They dive deep into financial statements, annual reports, quarterly earnings reports and industry trends. Their goal? To figure out a company's true worth, also known as the 'intrinsic value'.

Once investors have estimated this value, they compare it to the current stock price on the stock exchange (like the ASX ). If the stock is trading significantly below its estimated value, they might decide it could be a good buy. The idea is to buy these undervalued stocks and wait patiently for the market to recognise their true worth.

Some key metrics value investors use include:

• Price-to-earnings ratio : compares a company's stock price to its earnings per share
• Price-to-book ratio: compares a company's market value to its book value
• Debt-to-equity ratio: shows how much debt a company is using to finance its assets

Key concepts of value investing

1. Long-term approach

Value investors are in it for the long haul. They focus on holding stocks for at least several years, believing the market will eventually recognise the stock's true value. This requires both patience and a good understanding of market behaviour.

2. Identifying undervalued stocks

This is the crux of value investing. To find undervalued stocks, investors look at various financial metrics and company fundamentals. They aim to buy stocks where the current price is lower than the company's intrinsic value.

3. Focus on fundamentals

Value investors focus on the underlying fundamentals of a company. This includes factors like the company's earnings, revenue, dividends, and management quality. They invest in companies with strong fundamentals, even if the market has temporarily undervalued them. This can happen when the market reacts negatively to short-term issues that don’t impact the company's long-term potential.

Using value investing as a wealth-building strategy

As with any investing strategy, there are no guarantees in value investing. With that said, to practise value investing, an investor would start by doing their homework. This could mean analysing financial statements, understanding the business, and looking at the market conditions.

Value investing also requires patience. If an investor has chosen successfully, it may take time for the market to recognise the intrinsic value of their investments. A diversified portfolio can potentially help manage risks while still aiming for returns.

Value investing allows for more hands-on decision-making and can be rewarding if done correctly. But remember, like any approach, it has its risks. Always conduct thorough research and possibly consult with a financial adviser before making any decisions.

Strategies of successful value investors

When discussing value investing, mentioning Warren Buffett and the late Charlie Munger is inevitable. These investment giants, the powerhouses behind Berkshire Hathaway , consistently applied value investing to create significant wealth.

Let's explore how they’ve used value investing to build wealth:

Long-term focus

The Berkshire Hathaway approach is to always look at the long game. They don't chase quick profits or trendy stocks. Instead, they invest in companies they believe will stand the test of time. They often hold onto these investments for years or even decades. This approach seeks to minimise the impact of market volatility and leverage the power of compounding .

Strong fundamentals

For Warren Buffett and Charlie Munger, a company's intrinsic value is a key focus. Together, they dived deep into understanding the business, looking at earnings, revenue, and future growth potential. They also sought to avoid speculative investments and stick to enterprises with tangible value.

Emphasis on quality

Both Buffett and Munger are known for their rigorous standards. They didn’t just hunt for companies with strong fundamentals. They also looked for excellent management and a competitive edge. Beyond that, they prioritised businesses with a clear and sustainable business model.

Buying undervalued stocks

Buffett and Munger excelled at finding shares priced below their intrinsic value. Throughout their partnership, they scrutinised financial statements and industry conditions to identify these opportunities. This strategy allowed them to buy high-quality companies at a discount, which can reduce risk and increase potential returns.

Patience and discipline

One of the hallmarks of their success was discipline. They didn't follow market trends or make impulsive decisions. Patience ensured they made informed choices, and discipline kept them on course. It was about consistency and sticking to their principles.

Real examples

Berkshire Hathaway’s portfolio includes stakes in companies like Coca-Cola , Apple , and American Express . These aren't flashy tech startups, but companies which Buffett believes boast solid business models and strong competitive advantages. They’re also not just random picks; each investment goes through rigorous scrutiny and aligns with their long-term objectives. Coca-Cola, for instance, has been a part of their portfolio for over 30 years, demonstrating their commitment to holding onto businesses they believe in.

By focusing on fundamentals and a long-term mindset, Warren Buffett and Charlie Munger turned Berkshire Hathaway into a powerhouse of value investing. While their strategy isn't applicable to every investor, their example can offer inspiration for anyone looking to build wealth sustainably.

What are the potential benefits of value investing?

Value investing offers several potential benefits for long-term investing. Here are some possible advantages to consider:

• Long-term growth: Value investing often focuses on a company’s long-term potential. Buying undervalued stocks creates the potential for substantial appreciation as the market recognises and corrects the mispricing. This long-term approach aims for compounded growth over time.
• Margin of safety: A key principle of value investing is buying shares at a price lower than their intrinsic worth – the margin of safety. When done correctly, it can provide a cushion against market fluctuations and reduces risk. It can also potentially increase the chances of positive returns even if some investments don’t perform as expected.
• Focus on fundamentals: Value investors pay close attention to a company’s fundamentals, such as earnings, dividends, and growth prospects, enabling more informed decisions. This disciplined approach can potentially lead to more stable and predictable investment outcomes.
• Reduced emotional investing: Value investing encourages a disciplined and calm approach. By focusing on a company's intrinsic value rather than market hype, investors can possibly avoid the pitfalls of emotional decision-making.
• Dividends and income: Many value stocks are well-established companies that pay dividends . These regular payouts can provide a steady income stream in addition to potential capital gains. This can be particularly appealing for investors seeking both growth and income from their investments. Keep in mind, though, that dividends are not guaranteed, and can cease if a fund or company underperforms.
• Historical success: The success stories of Warren Buffett and Charlie Munger with Berkshire Hathaway showcase an effective example of value investing. Their disciplined and patient approach to identifying undervalued companies has generated impressive returns over decades. However, keep in mind that past performance doesn’t guarantee future results.

What are the potential risks?

Every investment strategy carries risks, and value investing is no exception. While it can be a strong path to building wealth, it's important to understand the possible downsides.

• Misjudging intrinsic value: Investors may incorrectly assess the fundamental worth of a stock. This can lead to purchasing shares that don't offer the expected undervaluation and potential for growth.
• Longer time horizons: Value investing often requires a longer time horizon to see results. The market can take a long time to recognise a stock's true value. This may test your patience and financial commitments. If you're not prepared to wait, you might not see the returns you anticipated.
• Market conditions: The broader market environment can impact the success of value investing. Economic downturns or prolonged bear markets can affect even fundamentally strong companies. This makes it harder for value stocks to realise their potential.
• Company-specific issues: Even well-researched investments come with company-specific risks. Changes in management, poor business decisions or industry disruptions can affect a company's performance. While you may invest thinking a company is undervalued, unforeseen issues can expose your investment to new risks.
• Opportunity cost: Allocating funds to value stocks means these funds aren't available for other potential opportunities. If value stocks take longer to perform, you might miss out on gains elsewhere. This is a common risk for any long-term investing strategy.
• Financial discipline: Value investing requires a disciplined approach. It can be tempting to react to market fluctuations or media hype. Staying the course and trusting in your research takes emotional fortitude and consistent financial sanity.

Each investing strategy has its nuances. Weigh the potential benefits and drawbacks before choosing your path, and when in doubt, speak to a financial adviser.

How is value investing different from passive long-term investing?

Value investing and passive long-term investing are both popular strategies among investors. However, they differ significantly in their approaches and objectives.

As we detailed earlier, value investing is about finding and buying stocks undervalued by the market. It’s a form of active investing . Unlike passive investing, which involves holding a diversified portfolio that mirrors a market index, value investing requires a more hands-on approach. It entails:

1. Extensive research : Value investors spend significant time researching companies.
2. Selectivity : Rather than buying a broad market index, value investors handpick individual stocks. As mentioned, it’s about looking for companies with solid fundamentals.
3. Market timing : While not trying to time the market in the traditional sense, value investors do look for favourable buying opportunities. They prefer to buy stocks during market downturns or when the market overlooks a company's potential.

On the other hand, passive long-term investing involves buying a broad range of stocks to mirror the overall market or a specific index. This technique, often referred to as index investing, aims to match the market’s performance rather than outperform it. Investors generally choose low-cost index funds or exchange-traded funds (ETFs) and hold on to them, benefiting from the market’s historical growth over time.

Let's compare the two approaches:

Aspect	Value investing	Passive long-term investing
Strategy	Buy undervalued stocks	Mirror market/index performance
Focus	Individual company fundamentals	Broad market trends
Investment selection	Selective and research-intensive	Broad and diversified
Time commitment	Active investing approach - requires ongoing analysis and updates	Minimal; set and forget
Risk management	Diversifies less; more focused on specific stocks	Diversifies widely across the market
Objective	Outperform the market by identifying bargains	Achieve market returns over the long term
Example instruments	Individual stocks	Index funds or ETFs

Understanding these differences can help you decide which strategy aligns with your investment objectives and style. Each approach has its merits, so consider what fits best with your needs as an investor.

Is value investing right for you?

Value investing can be a viable strategy for patient, long-term investors willing to do their homework. It requires discipline, thorough research, and the ability to stick to your convictions even when the market disagrees.

However, it's not the only way to invest. Some investors prefer growth strategies, focusing on companies with high growth potential rather than undervalued stocks. Others opt for passive investing through index funds.

Choose an approach that aligns with your financial goals, risk tolerance, and the time you're willing to dedicate to managing your portfolio.

Remember, even Warren Buffett acknowledges that value investing isn't easy. It requires continuous learning and adaptation. But for those willing to put in the effort, it can be a rewarding way to approach the stock market.

Whether you decide to follow in Buffett's footsteps or choose a different path, make sure you do your research, or chat with a financial adviser.

Happy investing!