We have discussed at length on the benefits of ETFs and how that should form the foundation of your investment portfolio, but I have also been in the City long enough to know that the excitement of the stock market is alluring and we would still want to have some single ticker exposure.
My response to this is always, if you are looking for excitement, go to the casino. In the world of investment, boring is good, simplicity is good because boring and simple probably has a higher chance of making money than exciting and complex investments.
Having said that, if you are keen on investing in the stock market, value investing is probably the way to go. Value investing is what Warren Buffett and Charlie Munger used to build Berkshire Hathaway and it has proven its resiliency across multiple black swan events.
What is Value Investing?
In a nutshell, value investing is a 3 step investment strategy:
- Identifying stocks that are undervalued by the market.
- Purchasing these stocks at a discount to their intrinsic value.
- Holding these investments until the market corrects their undervaluation.
This is all well and good, but how do we put it into practice? Specifically how can we identify stocks which are undervalue? While careers are made and broken on this judgment call and universities offer year long courses on it, I will attempt to synthesize the key steps into the duration of an article for our general understanding.
Shortlisting: The first step is to shortlist a selection of stocks which meets our investment criteria. I generally do this by looking at key ratios like low Price to Earnings Ratios, low Price to Book ratios or High Dividend Yields. This provides a rough idea as to which are the quality companies where there might be alpha to be made in a market correction.
Analyzing: After compiling the shortlist, we zoom into individual companies to look at their financials. I focus on three key parts of the financial statements. Firstly, is the company profitable due to a sustainable recurring business (Revenue) or is it profitable due to once off events (eg. Disposal of assets). I also like to look at the debt levels to see whether they are taking on too much debt, or too expensive debt and whether they have any debt which is about to become due.
All of this analysis goes to address their cash flow position – how confident am I of their cash flow position next year and how are they using their cash. For example, if they are going into debt to boost their cash position to pay out dividends, this is going to be a no-go for me.
Evaluating: If the financial numbers look good, I move on to the next stage of analysis which looks to understand the business outlook. What is the market share which the company have currently, will this be growing in the coming years? How is the competitive forces in this industry, will this company be able to become a market leader? We want to ascertain the sustainability of the company’s fortunes and whether it has a competitive edge against its competitors and even whether this industry is growing or is it a sunset industry.
Calculating: So we have found a great company, the finances look solid, the business is sustainable and we want to invest in it, but what is the right price to invest in? This is where we bring out the excel modeling skills and start running a few models to answer the question, what is the intrinsic value of this company and its share. Common models used for this calculation include the Discounted Cash Flow analysis (DCF), the Earnings power value (EPV) and comparable company analysis where we look at other similar companies to draw a benchmark as to what the intrinsic value is.
Margin of Safety: The margin of safety is a critical concept in value investing. It says that when we compare the intrinsic value to the current market price, we should only invest in the share if its current market price is trading at a significant discount to the intrinsic value (eg. 30% or more). This allows us to minimize our investment risk through the margin of safety and when the share price reverts to the norm, we can profit from it.
Investing and Monitoring: Assuming all of the above steps are fulfilled, we can go ahead with the investment and commit to it. We also have to continuously monitor and review our positions in case there are any changes to any of the assumptions which we might have made in the analytical process above.
Case Study
It is easy to write a list of steps, but let me try to apply it to an actual ticker so that you can better understand the thought process:
- Shortlisting: Looking through stock scanners, I find Delta Air Lines (DAL) to be interesting with a P/E ratio of 6.7, which is lower than the average P/E ratio for the airline industry.
- Analyzing: DAL’s profitability has been rising annually and recovered well since the Covid days. Cash flow has also improved with free cash flow totaling above 1 billion, DAL has also improved its debt position with debt pay down. Given the airline industry’s reliance on debt, its high debt position is typical with the industry.
- Evaluating: DAL’s competitive advantage boils down to its brand reputation, global network and operational efficiency, but ultimately the airline industry is very susceptible to global shocks and the product might not be that well differentiated to the end consumer.
- Calculating: Using a discounted cash flow model, we arrive at an intrinsic value for DAL shares to be around 70 USD, the current market price is around $52 which gives us a margin of safety of around 33%. This fits in with the general numbers we look at when considering margin of safeties.
- Investment: To go or not to go? While this investment seems to tick all the boxes, I am still skeptical about investing in the airline industry as a whole. I decide to still invest, but to write a small check for DAL and to focus the majority of my firepower on the S&P 500 ETF.
- Monitoring: Let’s hope no black swan events throw the airline industry into jeopardy once again.
Further Readings
Lastly – I think it is very important to educate yourself on the finer details of value investing. Should you like to go down that rabbit hole, here are some other books for you to deep dive into:
- “The Intelligent Investor” by Benjamin Graham
- “Security Analysis” by Benjamin Graham and David Dodd
- “Common Stocks and Uncommon Profits” by Philip Fisher