Value investing involves the use of reason and analysis to make rational investment decisions. The value investor should always give sufficient consideration to an investment before making a move. This involves performing a specific series of checks on the stock before purchase. Although the checks such as consideration of ratios, appraising the management and looking at the intrinsic value of the stock are considerations common to all value investors, each particular investor will have a preferred approach to the evaluation of the stock. The approach taken by the investor should be adapted to the specialist knowledge and background of that investor.
The value investor should always consider financial checks but should also be prepared to make more general judgments about aspects of the company, it strategy, future plans and the quality of its management. Much useful information, both numerical and non-numerical, can be found in the annual report. The value investor should never rely on just one financial indicator, and should never treat the result of a financial test as conclusive. Whatever metric the value investor chooses to look at this is just a first indicator that a stock may be interesting to the investor and should be followed up by further research including the use of other financial ratios.
Having established a method of looking for stocks the value investor should not then try to second-guess or short-cut the system by jumping onto apparent bargain offers without performing the usual checks. If the investor has decided to look systematically for value stocks and employ certain types of analysis to identify those stocks, it makes no sense to abandon this method for a quicker and less rational approach in the hope of a quick gain. Value investing requires more patience than some other types of investing because it may be some years before the market value of a stock rises enough to approach its intrinsic value. The reward for this patience is however likely to be greater than the reward gained through jumping on to short term band wagons.
As value investing is based on knowledge and understanding of the stock it follows that the value investor should always invest in an industry that is well understood and where the investor can reasonably understand the trends in the industry and the different approaches taken by the different players in that sector. Warren Buffett once suggested that if he was interested in a certain stock he would obtain the annual reports of its competitors. It would be possible to compare the companies in the same industrial sector and understand the competitive advantages possessed by some of those enterprises. The value investor would normally be looking for a company that is a leader in its industrial sector and has competitive advantages that give it a moat of security from attacks on its market share by competitors. Identification of the leading company in the sector involves a study of all the players in that industrial sector.
As already suggested, the value investor should attempt some kind of calculation of the intrinsic value of the company. This is after all what identifies a true value investment. The stock should have an intrinsic value well above its current market value and there should be a good margin of safety between the two values. There is no foolproof way to compute the intrinsic value as this is an estimate of future net cash flows over the life of the stock. An investor may choose an analysis based on discounted net cash flows or could use one of the tools available online to arrive at the intrinsic value. These tools should not be used without thought. Value investing is based on understanding the stock so the value investor should look critically at the result of the intrinsic value calculation and apply personal judgment in assessing this result. Where the investor considers that the margin of safety is insufficient it is best to wait for a moment when the stock has fallen far enough to give a better margin of safety and then move in a buy, provided that the analysis performed earlier is still valid.
The essence of investing based on understanding rather than emotion is the exercise of patience by the investor. Sometimes it is not the right time to buy the stock and the investor should wait. If the analysis of promising stocks shows that there is no stock fulfilling the requirements for making an investment, the most rational course of action is to do nothing. The main qualities required in a value investor are therefore patience and the use of reason. If an analysis of the stocks shows that the best course is to do nothing and wait, the investor should do this. In this way the investor will not be swayed by emotion and is less likely to be led into misguided investments.