Value Investing

What You Have To Know Before You Start Value Investing

What You Have To Know Before You Start Value Investing by Evan Bleker — Net Net Hunter

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Should you be value investing if you don't know how or will you just end up losing all of your money?

Value investing can seem scary if you're just starting out. I definitely felt the same. The main principles of value investing are very straight forward: each stock reflects real value but also has a market price, the two can differ, and you should aim to buy below real intrinsic value.

Beyond that, though, value investing can become very complicated very quickly. I recently received a great email from one of our members with questions about value investing. If you're new to value investing then this article will be critically important to launching your own value investing portfolio:

Hi, Hope all is well. I have a general question about value investing, probably rhetorical: is it wise to invest money in net net stocks when you don’t really know what you’re doing - i.e. just buying/selling when someone experienced like you says so? At the end of the day, it’s about buying/selling the right stocks at the right time, no? The reason I ask is b/c I have a little bit of money to invest (a few thousand), but it’s not enough that I can risk/justify loosing it.

There is a whole lot here to unpack which is great because it will allow me to write about things I wish I knew when I first started value investing.

Before You Start Value Investing You Should...

It's pretty much always true that you should know what you're doing before embarking on your value investing career.

In situations like this, where you're investing your own money in stocks without the help of a competent family member (someone you can count on absolutely to work in your own best interest), knowing what you're doing is absolutely key.

When I first started value investing I began following the advice of two brothers who were fairly well known in the retail investment community. I wont mention their names because I don't want to get sued. I bought two of their books, scraped up the money I had, and plunked it down on a few stocks following their advice. If I knew what I knew now I wouldn't have touched their books in the first place. As it turned out, they were far better marketers than they were investors. I ended up losing a lot of money.

What You Have To Know Before You Start Value Investing

It's a cruel world out there. Be careful who you trust when you start value investing.

Unfortunately, it's true that you have few friends when you first start value investing and a lot of people like to claim records or investment prowess that they don't actually have. Lies and marketing can destroy your financial future, so get as much knowledge about value investing in your head as you can.

Of course, depending on the strategy that you employ, you don't have to have a Warren Buffett-like understanding of value investing but you should have a minimum level of investment knowledge or background. Having that understanding is very important when it comes to assessing investment choices yourself.

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Luckily, gaining that knowledge is easier than you think. While the field of value investing is large, you don't have to become an expert on all of it -- but you should focus on developing a solid understanding in the areas in which you want to invest. Warren Buffett calls this a "circle of competence" and I think it is very important whether you are investing your own money or trusting an adviser to do that for you.

In the field of stocks, some value investors look at growth stocks, some invest in companies based on free cash flow, while others look at private market value to get a sense of what the company is worth. I think simple strategies are best since even the classic low PE value investing strategy can become complicated very quickly. You don't need a sophisticated value investing strategy to do very well investing in stocks -- as my own results have shown. Invest based on a set strategy and, at minimum, know the ins and outs of that strategy well.

Two Must Read Value Investing Books

Value InvestingIf you're interested in value investing then there are a lot of great value investing resources out there that you can take advantage of.

The absolute best books on value investing are the Security Analysis books by Graham and Dodd. These books are great because they are oceans deep in terms of investment theory and based on a strong philosophic foundation cultivated through years of study and practice on Wall Street. Graham's investment firm racked up some very good returns using the same theories and techniques he preached in his writings, providing strong evidence for the usefulness of those theories and tactics. Incidentally, the record and simplicity of his value investing strategies is why I decided to start investing in net nets in the first place.

I would call Benjamin Graham one of the best business minds of all time -- he's widely regarded as the father of value investing. He was also a great communicator. Since Security Analysis was his best work, that also makes Security Analysis one of the best business books of all time. I have both the 7th ed. and the 1951 ed. and have read both multiple times. I recommend the 1951 ed. since it reflects an evolution of Graham's value investing philosophy since the 1930s.

Value Investing

If thumping through 770 pages dedicated to value investing doesn't sound like a good time, Graham wrote The Intelligent Investor for you. The Intelligent Investor was the everyday investor's handbook and contained his major thoughts on value investing.

Warren Buffett, the best investor of all time, called this book the best business book of all time, and for good reason. I've read both many times and will likely read them many more times in the future. I've linked to each book here to help you find them. Serious investors should read Security Analysis but at only $15 The Intelligent Investor is a steal.

Finding Info on Benjamin Graham's Best Value Investing Strategy

Of course, it's no secret that I've opted for Benjamin Graham's net net stocks strategy. Seeing as it is the most proven high performance value investing strategy, why would anybody want to use anything else?

When it comes to learning about net net stocks, I haven't found many resources out there aside from brief commentary in Benjamin Graham's books and a number of papers published on net net stock investing. The papers themselves were very good for helping me sort out an optimal investment strategy -- they cover a wide range of techniques that investors can use to beat the market using a net net stock strategy but some techniques work better than others. Since you're a member, you can learn about best practice techniques in our Resource Center.

The serious lack of resources on net net stock value investing is why I decided to put together the Net Net Hunter Resource Center in the first place. It's my attempt to synthesize the writings of Graham, knowledge from a number of research studies, as well as my own experience into an accessible & usable framework for guys like you to follow.

If you want to make net net stock investing a key part of your investment strategy (or any other type of value investing method, for that matter) then you owe it to your self to dig deep down to understand the mechanics of that strategy. Once you understand them, you have a better ability to ask questions and sort good investment advice from bad.

So, the short answer is that you should have a minimum amount of investment knowledge before you start to invest but that knowledge is much easier to acquire than you think. Now what about the risk factor?

How Risky is Value Investing? Diversification

I define risk in terms of long term price decreases or permanent losses. If the stock price goes down and is likely never coming back up, that's bad. If the stock goes down and doesn't recover for a very long time... that's not much better. Essentially, risk is the chance that that will happen, what the likelihood of specific long term or permanent losses are.

While I have only ever had one or two net net stocks that led to meaningful losses, I estimate that roughly 20-30% of my stock picks have done badly -- the returns earned from my good picks have dwarfed any losses caused by my bad picks, though. That's just the way it goes with value investing -- nobody has a perfect record.

Here's the thing: net net stocks work out exceptionally well when you invest in a basket of these stocks with promising investment characteristics and maintain a medium to long term perspective. The exact same thing can be said for any value investing strategy.

That first caveat is important -- while the majority of these net net stocks work out extremely well, it is possible for any one stock to do badly. That's why you should diversify your value investing portfolio to some extent. The extent of your diversification when value investing really depends on on the specific net net stock investment strategy that you're using and that depends on the amount of work you want to put into picking your stocks and the amount of accounting or business knowledge you have.

I really love the book Contrarian Investment Strategies, by David Dreman. Dreman is himself a very successful professional investor and has been value investing for a long-time. In the book, Dreman looks at groups of companies that have specific value characteristics and and shows how putting together a diversified portfolio of these company produces above average results. This type of value investing takes advantage of population returns, remember, so you really should put together a large basket of these companies to achieve the same outstanding performance. As a group they work out, but any one stock can perform poorly.

The key is diversification. Since you're fairly new to value investing I recommend that you hold a larger number of stocks in your portfolio. Concentration leverages stock picking ability while diversification helps you mirror population returns and makes up for a lack of skill or experience when value investing. Obviously, Graham's net net stocks strategy is the most tested high performance value investing strategy, though, and diversified portfolios of net net stocks do very well.

Value Investing Requires Looking at Things Within the Context of Eternity

Short term paper losses are inevitable and should be seen as an opportunity if you're going to be value investing. A simple fact about value investing is that many stocks fluctuate by quite a lot during the course of a year. In my own experience, a stock I have invested in typically sinks in price by 10-50% after I buy it only to rise back up to my purchase price then eventually increase to reflect the firm's net current asset value.

As an investor, you have to be able to stomach situations like these no matter which investment strategy you choose to use: low PE, discounted future cash flow, or even a net net stock strategy.

Another thing you have to keep in mind is that this is a long term strategy, not a short term strategy. You can make a lot of money in the short term using a net net stock value investing strategy but these short term results are definitely not consistent. Every single value investing strategy will underperform from time to time -- periods when your whole portfolio sinks into the red. The business cycle often makes sure of that. Every few years the market will decline in value by quite a lot likely pulling your portfolio down with it. If it's a true crisis, like it was in 2008/9, then your own psychological makeup will be put to the test.

Charlie Munger says that if you can't be philosophical about temporary price drops then you deserve the poor results that you're going to get. Graham said, quoting Dutch philosopher Spinoza, that you have to look at things within the context of eternity. Luckily for long term investors, the market has always seemed to rebound -- over the last 130 years at least -- making these types of crises a perfect time to load up net net stocks.

Think of eternity when value investing.

Ironically, the biggest risk factor when value investing might be your own psychological makeup. That's why it's so crucial to take a long term perspective on your value investing program. Short term losses will happen frequently and should be seen as an opportunity, not something to try to avoid. What you want to do is avoid making serious errors that cause long term losses.

Two Critical Traps When Value Investing

Two specific traps that people new to value investing fall into are skimming and psychological denial.Trying to get the last nickle for their stocks, or trying to buy a hair cheaper than what the stock is priced at, might seem like a good idea but it's really a fool's game. Skimming when value investing is a great way to erode your investment returns over the long run by causing you to miss investment opportunities or sell a stock only to watch it sink. Psychological denial is a whirlwind of psychological defenses that your ego employs to keep you from feeling badly but it just ends up hurting your investment results over the long term. Make sure to stay clear of those.

The Most Promising Value Investing Strategies

Graham's net net stock strategy are by far the simplest and most profitable value investing strategy you can employ but not all net net stock opportunities are created the same. Some are far more promising than others.

 

See the light -- choose your value investing strategy.

When I look for net net stocks I always refer to my NCAV stock scorecard. Using a value investing scorecard  is great because it forces you to assess different aspects of an investment that you might otherwise overlook.

Screening out unpromising investments is just as important as selecting great ones. For net net stocks, I'm often trying to eliminate investment candidates rather than affirm any specific net net stock. Net net stocks that don't seem to have anything going for them can still do very well. When Warren Buffett was using NCAV stocks as his main investment strategy back in the 1950s and 1960s, he wrote that often there's no reason to buy the stocks he buys other than a cheap price. Another way of saying this is that there doesn't have to be anything promising in the company's story to warrant a purchase so long as the stock is really cheap relative to value.

Getting back to eliminating stocks when value investing... The net net stock studies that I read looked at the entire population of net net stocks and showed that, as a whole, NCAV stocks had returns far above the market or any other value investing strategy. Screening out stocks that have a lot of debt relative to equity, have been trading below NCAV for a number of years, haven't had a satisfactory level of income prior to becoming a net net stock, or are just unstable businesses, can boost those returns even higher.

This works by helping you avoid losses which can kill your portfolio so obviously screening out certain companies can reduce your overall risk. By reducing risk and avoiding loss you end up investing in more stocks that ultimately pay off. This is huge when it comes to making large returns.

It's also why I always tell people not to trust stock screeners when value investing. You want to get to the actual financial statements of the company to see what's really going on.

When to Buy and Sell When Value Investing

You're right that investing in stocks just boils down to when to buy and sell the right stocks. Unfortunately, predicting the price movements of stocks is very difficult. It's hard to know when you are buying at a price from which the stock will rise over time. To help, value investors base their buy and sell  decisions on value. The idea is that the price of a security and the true value of that security tend to converge but can deviate wildly in the short term. That deviation is what the intelligent investor takes advantage of when selecting investments.

The right time to buy a stock is essentially when the stock falls well below its true value. On the other hand, there can be many different reasons to sell a stock.

This is the general concept but the devil is in the details. To know when you're buying well below intrinsic value you first have to know what the intrinsic value of the security is. There are many different theories and techniques for assessing the intrinsic value of a security but the one I have found most useful has been the net current asset value represented by the security. It's both simple to calculate and has proven to be very useful in practice.

Where to Start Value Investing

I suggest that you start value investing in your own home country, but don't develop self-imposed blinders. Investing at home will be more comfortable for you at first and help you focus on developing the value investing process. There will be fewer details that you immediately have to acknowledge, such as currency conversions, and that will help you to build core skills and knowledge.

Don't let that bias bog you down, though. A lot of investors fail to find the best stocks because they fail to look outside their own domestic market. That's a huge handicap that average investors place on themselves. The best investors I know of look for great investments in English speaking first world markets. That's why Net Net Hunter focuses on these markets when uncovering great value investing opportunities.

The one exception is our inclusion of Japan -- but it was a no-brainer to include that market because it's a well developed first world market with tonnes of very cheap value investing opportunities. Stocks are dirt cheap in Japan and Japanese value stocks have done incredibly well over the last 30 years. Take a look at the book, "Investing in Japan," by Steven Towns, and at these 5 international stock brokers you can use.

I hope that goes a long way to answer your questions. Make sure to send me another email if you have any followup questions.

Cheers,

Evan