In order to understand the principles of value investing, a thorough understanding of the difference between “investing” and “trading” is important. A trader takes long and/or short positions in order to gain short-term profits by capitalizing on price movements caused by short-term disparities in the supply and demand of the moment. To a trader, the fundamental wellbeing of the underlying corporation (or economy in the case of the forex market) matters not. A trader’s only concern is the price volatility of the asset. Even if a corporation has the worst fundamentals in its sector, so long as there is sufficient average daily price range and volume for a trader to capitalize on, a trader will do so. A trader makes trading decisions based solely on the technical analysis of recent and current price data. The fundamental of the underlying corporations being traded are all but ignored by traders.
By contrast, an investor embraces a long-term approach, and only takes long positions on assets which are perceived to be underpriced (undervalued). In the case of a stock, investors analyze the underlying corporation’s fundamental data including earnings-per-share, profitability ratios, revenues, costs, market share, etc. in order to find stocks that are priced by the market below the calculated intrinsic value, and therefore perceived to be a good “value investment.” The investor then takes a long position and holds the asset until such time that the security actualizes the investor’s target perceived market value. Thereafter, if growth potential in the stock remains, the investor may continue to hold the stock until there is a reason that compels the investor to assume that the value of the stock will diminish, at which time the position is liquidated, and the profit is realized.
Unlike the trader, investors don’t concern themselves much with technical analysis of recent and current price data. Fundamental analysis is the basis by which value investors make their determinations as to whether a corporation is considered a valid value investment. Fundamental analysis refers to the detailed analysis of fundamental metrics of the underlying corporate financial reports in order to make an informed and rational decision on the merits of an investment.
Corporations are obligated to periodically publish fundamental financial data, either on a quarterly, bi-annually, or annual basis, depending on the data. Consequently, fundamental analysis is typically used to analyze the long-term outlook of a corporation.
How Value is Created
For a stock, value is created in one of two ways. The first is the result of a discernible improvement in the corporation’s fundamentals. The improvement can result from various factors associated with corporate operations including an increase in sales, a significant decrease in costs, the introduction of a new product or technology, or the expansion into a new market. Improvements can also come in the way of intangible factors such as the hiring of new executive management, the passing of legislation favorable to the corporation, and even the demise of a competitor. All these factors, along with many others cause the value of the corporation to increase. The second way that value is created is for the price of a stock to take a significant drop for reasons that are external with respect to corporate operations. When a corporation experiences an event, be it internal or external in nature, that results in unfavorable ramifications to their fundamentals, price and value are both diminished. In this case, a lower price does not necessarily mean greater value. However, when the entire market or sector experiences a significant drop in prices across the board, while the operations of a corporation remain static, value is created vis-à-vis lower prices. For example, bear markets often result in lower stock pieces, which creates value-investment opportunities.
DAILY CHART: S&P 500
The above chart shows the S&P 500 going back to 2008, a universally accepted measure of the US stock market. The chart indicates a general upward trend with several temporary dips, referred to as Bear Markets.” During these bear markets, stock prices drop; sometimes significantly as in the case of the market crash resulting from the Housing Bubble Crisis at the end of 2008. The crash was the result of investors panicking, not weak corporate fundamentals. Once the panic subsided, and the market bounced off its bottom, investors started buy like there was a “fire sale at the mall” simply because of the value create by very low stock prices.