9 Key Principles of Value Investing

Value investing, or the art and science of buying a stock at a discount to what it's really worth, has built a lot of fortunes. Some of the world's most famous investors, including Berkshire Hathaway CEO Warren Buffett and Fidelity Investments' Peter Lynch, have used a value investing approach to generate outsized returns for themselves and their investors over time.

You don't have to be a legend to generate market-beating returns with a value investing strategy. But if you want to understand how to be a successful value investor, it will help to keep these nine principles in mind.

1. Value investing is different from speculation

Benjamin Graham, widely considered the founding father of value investing, exhorted would-be investors to clearly understand the difference between investing and speculation. Here's how he put it in his all-time classic book, The Intelligent Investor:

There are several key ideas packed into those two terse sentences, and we'll explore them all below. But the big one is this: Value investors aren't looking for the "next big thing," a company that might become a great company in time. The giveaway is that word "might." To Graham, if the investment case for a company involves things that could happen in the future -- but won't definitely happen -- then it's speculative. Most highly touted growth stocks fall into this category.

Simply put, speculators, in Graham's view, look for companies that could have a much greater value in the future, depending on events. In contrast, value investors seek to buy companies at substantial discounts to their true value today, and hope that over time, other investors will recognize that true value and bid up the price of the company's stock.

2. Value investing depends on the intrinsic value

Proponents of the efficient-market hypothesis argue that a stock's price instantly reflects all available information -- or put another way, that it's impossible to consistently beat the market, and investors are best off matching the market with index funds.

Value investors believe that over the long run, a stock's price generally matches the underlying value of the company or its intrinsic value. But they also believe that stocks can be mispriced in the near term, and they look for stocks that can be bought at substantial discounts to intrinsic value.

Whether it's because of a stretch of bad news, the misfortunes of a similar company, good news that hasn't been widely recognized, or a marketwide stock sell-off, there will be times when the stocks of good companies are priced at a discount to what they're really worth. Value investors try to buy those stocks in those moments. They then hold those stocks until their prices rise to match their intrinsic values -- or, in other words, until they revert to the mean.

How to find a stock's intrinsic value:

Investors use several different methods to estimate a company's intrinsic value. Perhaps the simplest is to start with the company's price-to-earnings ratio, or "P/E ratio," the ratio of earnings per share to the company's current stock price. Think of it in terms of earning power: A stock selling at 5 times earnings offers you more earning power per share than one selling at 15 times earnings.

Generally, similarly situated companies in a given sector will trade at roughly the same P/E ratio. When you find a company with a P/E ratio significantly lower than its peers, you might have found a value stock.

For instance, right now, General Motors is trading at just 5.6 times its 2017 earnings (when adjusted to exclude one-time charges). Healthy automakers have historically tended to trade around 8 to 10 times earnings, and a quick look shows us that several of GM's rivals, including both Toyota and Fiat Chrysler Automobiles, are in that range now. Investors will need to look more closely to be sure that GM is financially healthy, but if it is, then its intrinsic value might be more like 8 to 10 times earnings.

Investors often apply the principle of the P/E ratio to different metrics: We might calculate a "forward P/E" by dividing the company's stock price by its expected earnings per share for the year ahead. We might also look at other price ratios, like price-to-cash-flow or price-to-sales, and see how those compare to similarly situated rivals'.

Of course, stocks are sometimes cheap for a reason. Maybe the company's earnings have been stagnant for several years or even declining. There's another related ratio that helps us see if a company with earnings growth is selling below its intrinsic value. It's the price-to-earnings-growth ratio, or "PEG ratio", the company's price-to-earnings ratio divided by its earnings growth rate. The idea is that a company with a PEG ratio of 1 is more or less properly valued. If you find a company with a PEG ratio below 1, it could be selling at a discount.

Peter Lynch has said that the PEG ratio is one of his favorite indicators. It's a useful way to identify companies that might be selling at discounts. But as with all of these ratios, the PEG ratio is a way to identify companies that might deserve a closer look. You'll need to do more research to rule out the possibility that the company's stock is cheap for a good reason.

3. Value investors seek a margin of safety

The difference between a stock's intrinsic value and its current market price is called the margin of safety. The key to value investing is to find stocks with a good margin of safety -- or put another way, plenty of upside potential.

But how do you find companies with a good margin of safety? Sometimes, you'll stumble across a situation that stands out. There was a point in 2003 when Apple's market cap was less than its cash on hand. In retrospect, that was a screaming "buy" signal for value investors. But more commonly, you'll have to figure it out by screening for companies that look like promising value investments, using metrics like the P/E and PEG ratios that we discussed above.

There's another related metric that can help identify companies with good margins of safety. It's the price-to-book ratio, where "book" is the company's "book value", its total assets minus its total liabilities. For most companies, this is simple to calculate using the numbers from its most recent balance sheet. If you find a company trading for less than its book value, you might have found a company that you can buy for less than its assets are really worth. (That was the situation with Apple in the fall of 2003).

Be careful, though -- the price-to-book ratio doesn't work well as an absolute measure. Two very different companies could have wildly different price-to-book ratios, but both might be fully valued when compared to similar companies. Tech companies often trade at many times their book value, for instance, because software assets have intangible value that may not be fully expressed on the company's balance sheet. And automakers tend to trade at low multiples to their book values because their factories and tooling -- critical to their businesses -- are relatively highly valued. For reasons like these, as with the P/E ratio, it's best to use price-to-book ratios to compare companies within a specific sector or industry. But whatever metric you use, the goal is to find companies selling at a discount to their intrinsic values, and that discount is your margin of safety.

By the way, it's true that the margin of safety can also be thought of as a "margin of opportunity," but there's a reason we don't use that name. Remember that avoiding losses is our first priority: If a stock's price is lower than its intrinsic value, it's less likely to take a steep dive during periods of market volatility. It's less likely to drop sharply and suddenly if the company's sector moves out of favor with investors.

The idea of a margin of safety is a key principle of value investing. It helps insulate your portfolio from shocks that hit the broader industry or the market as a whole. And, of course, it also represents the potential upside of the investment: If you've bought at a discount to the company's intrinsic value, you can assume that the stock's price will rise closer to its intrinsic value over time.

But in order to understand whether a calculated margin of safety is a real one -- or put another way, in order to understand why the stock seems to be cheap -- you'll have to spend some time learning about the company and its situation.

4. Think in terms of years or decades, not weeks or months

Sometimes, it can take a company a long time to see its share price rise to match its intrinsic value. If you have the time and if you won't need the money for many years, you have an advantage over investors with the opposite circumstances: You can buy, perhaps at a discount, when they need to sell.

Good companies can trade at valuations that seem very low for years. This can happen when investors' attention is focused elsewhere (on hot tech stocks, for example) or when a sector is out of favor. In the early 2000s, following the dot-com crash, Altria Group was often touted as a value stock. Despite strong earnings and a growing dividend, Altria was trading at around 4 times earnings -- clearly below its intrinsic value. Investors who bought early were able to collect a good dividend, but as you can see from the chart below, Altria's valuation languished below 5 for a long time. Eventually, sentiment shifted -- in part because Altria spun off part of its tobacco business. Needless to say, investors who had bought early on and stayed patient were well-rewarded.

Even if it takes several years to happen, the general principle holds: The market is usually efficient over the long run, and eventually, a stock's price will reflect the company's true value. If you've bought the stock at a discount, you'll make money if you sell it once its price rises to something closer to its intrinsic value. Having the patience to wait until that happens is one key to success as a value investor.

5. Value investing requires a contrarian mindset

If you feel the need to "go with the flow" when you invest, value investing might not be for you. Almost by definition, investors looking for undervalued stocks are looking for investment opportunities that other investors have overlooked. You can sometimes find those companies by screening for indications that suggest the stock is cheaper than the company's true value -- but don't be surprised if you find them in corners of the market that seem wildly out-of-favor.

For starters, we know that a low P/E ratio, particularly for a company with earnings that are expected to grow, is a good indicator of a company that might be worth a closer look. Consider Ford Motor Company, which has a P/E ratio around 5.8. As we know, that's low for a global automaker, which should be trading at more like 8 to 10 times earnings.

With Ford, as with many value stocks, there's a story behind the valuation. Ford's earnings have been good, and its dividend is strong. But its earnings have slipped as costs have risen over the last couple of years, which hasn't helped it attract investors. And investors looking for growth powered by new technologies like self-driving and electric vehicles have tended to overlook Ford, which makes a lot of its money from pickup trucks. Compared to a company like Tesla, Ford seems like a relic from last century.

But here's the thing: If you take a closer look at Ford, you'll find a company with low debt, a big cash hoard, future-minded management, better technology than many realize, and a credible plan to reduce costs and boost profit margins over the next few years. That plan will also reduce Ford's dependence on those pickup trucks, by the way.

It sounds a little different now, doesn't it? But you have to look closely to see what's really happening -- and for many investors, Ford's story just isn't that interesting compared to Tesla's.

So is Ford a buy? That's for you to decide. But Ford is an example of the kind of company that often turns out to be a great value investment: A well-run company that has seen earnings slip and that has fallen out of favor in the current moment.

The larger point here is that successful value investing often means taking views that are at odds with conventional wisdom, or with the opinions of the experts who work at Wall Street banks and appear on television. That isn't always easy. The idea of investing real money in ways that go against advice from highly paid professionals can be daunting -- too daunting, for some.

But it's sometimes the most daunting investments that turn out to be the best value buys over time. If you think Ford is out of favor now, think of what it would have taken to buy it at less than $2 at the beginning of 2009, when the entire U.S. auto industry appeared to be doomed. Or consider Apple when it was trading under $10 in the fall of 2003, before anyone outside the company had heard the word "iPhone." Both were terrific value investments at those moments, but just about everyone -- professionals and amateurs alike -- would have told you that you were crazy to even think about buying those companies at those moments.

To succeed as a value investor, your confidence in your investing thesis has to be greater than your fear of looking or feeling foolish if you're wrong. It's not for everyone. But the good news is that in many cases when a value investor is "wrong," the result is a failure to gain rather than a big loss -- because value investors approach investment ideas with loss prevention high in their minds.

6. Avoiding losses is the first priority

For value investors, avoiding losses should be the first priority -- even over generating investment gains. It's simple math: If your portfolio's value drops by 25%, and then grows 25%, you've lost money. More to the point, in that situation, you need larger returns to meet your goals over time. That might lead you to take larger risks than you should, which could lead to more losses.

Successful value investors minimize the risk of big losses by investing at a discount to a company's intrinsic value. They may not always get market-beating growth, but if they can minimize losses (and the need to recover from those losses), they'll need less growth to meet their investing goals over time.

But how does a value investor avoid losses? By having a margin of safety.

7. Know what you own and why you own it

Value investing isn't a passive strategy. To be successful, value investors need to know the companies they own and why they own them. What does it do? Who are its competitors? Why is its stock selling at a discount? Why do you expect the stock price to rise over time?

It's important to know those things when you first invest, of course. But it's just as important to stay up to date on major developments affecting the company so that you can continue to answer those questions accurately. At a minimum, read the company's annual report and keep at least a half-eye on news pertaining to the company so that you understand if its situation is changing. If something happens that lowers its intrinsic value, you'll need to reevaluate: Do you still have a good reason to own the stock?

Remember: Minimizing losses is a high priority. If a company takes a turn for the worse, with no likely recovery on the horizon, selling its stock may be the best option, even if it means taking a loss. In order to understand whether that's true, you'll need to be familiar with the company and understand why you own its stock.

8. Think like a business owner, because you are

Great companies have great management teams. A great management team is focused on generating growth over time, which is the best way to reward long-term shareholders. Great managers probably aren't paying a lot of attention to the day-to-day fluctuations in the company's stock price.

Part of knowing what you own and why is getting to know a company's management team. Look for leaders whose incentives are aligned with shareholders. Great business leaders tend to have "skin in the game," a sizable amount of stock (or stock options) in the companies they run.

Sometimes these are businesses that started out as family businesses, as did Ford. The Ford family still controls Ford Motor Company via a special class of shares that grant them extra voting rights, along with dividends that match those paid to holders of Ford's common stock. Ford's chairman, Bill Ford, is a trustee of the trust that holds most of the Ford family's shares. His interests are closely aligned with those of long-term shareholders, and he has emphasized stewardship and a long-term view during his tenure.

But that said, corporate leaders that don't have big ownership stakes aren't necessarily bad leaders. Look at the company's annual report and its proxy statement to understand how the CEO is paid, and factor what you learn into your overall assessment of the company. Is it a company you want to own?

9. Seek an "adequate return"

Remember that Benjamin Graham quote? Graham taught that investors should always seek an "adequate return." By that, he meant a return that a reasonably intelligent investor was willing to accept.

But what should we be "willing to accept?"

Consider this: Any investor can get returns that roughly match those of the overall market's over time by simply buying an index fund or ETF. The goal of any active investing strategy, including value investing, should be to do better than that -- to beat the overall market's return over time. Let's return to the example of Ford. If you had bought Ford in that scary moment at the beginning of 2009, you would have nicely outperformed the S&P 500 Index over the next two years.

If you can't beat the market as an active investor, you're better off buying an index fund and doing something else with your time. In practice, for a value investor, seeking an adequate return might mean keeping your money in that index fund until you find opportunities that look likely to outperform the market over time -- stocks with large margins of safety.

In other words, a stock that's just a little bit undervalued probably isn't worth your time. Save your energy, and your investment capital, for the opportunities that look likely to give you an adequate -- above-market -- return.

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John Rosevear owns shares of Apple and Ford. The Motley Fool owns shares of and recommends Apple, Berkshire Hathaway (B shares), and Tesla. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Ford. The Motley Fool has a disclosure policy.