3 Types of Value Investing and Key Factors to Watch Out For

I had the privilege of being invited as a panelist to the Maybank Invest ASEAN 2023 event, where a thought-provoking question arose regarding the factors that investors should consider when performing value-investing analysis.

In light of this, I believe it would be valuable to share my insights and expand upon the answer here.

The concept of value investing can vary among different investors, lacking a fixed definition, which can lead to confusion and a loss of context if not properly defined.

Adding to this complexity, Warren Buffett has emphasized the interconnectedness of value and growth investing. As a renowned value investor, he blended the two, famously stating that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

From Buffett's perspective, value investing entails identifying companies with growth potential and strong competitive advantages that are trading at fair valuations.

Typically, superior businesses with growth prospects trade at a premium and may not be undervalued even during market downturns. Their price-to-earnings (PE) ratios can remain high, such as 30 times earnings, yet still be considered a fair price to pay.

These types of stocks are typically held for the long term, as they continue to compound in value. Some refer to them as "compounders" as a result.

For this category of stocks, understanding competitive advantages, or what Buffett calls a "moat," is crucial. Businesses operate in a competitive landscape and continually strive for market share. If there is no viable way to defend market share, the business becomes vulnerable and its value, along with its share price, can decline significantly. Determining the presence of a moat is challenging, and many investors underestimate this difficulty.

As a result, Buffett employs a "too-hard" pile strategy, whereby he refrains from analyzing a stock if he encounters difficulties in comprehending its business model, understanding its competitors, or lacks adequate visibility into its future prospects. However, we must watch our biases, which can cloud our ability to accurately forecast a company's future performance. In some cases, these biases may lead us to project a more optimistic outlook to justify our investment decisions.

Another crucial aspect is assessing whether the company's growth will continue in the future. Compounding takes time, so it is more important for a company to sustainably grow at 15% over the next 10 years than to experience a 100% growth in a single year. Higher growth rates do not necessarily indicate superior performance; sustainable growth is essential for compounding to occur.

The classic Benjamin Graham approach represents the second type of value investing, focusing on purchasing stocks that trade below their liquidation value. Graham likely developed this pessimistic approach due to his experience during the Great Depression.

Interestingly, Warren Buffett was one of Graham's disciples and initially built his fortune by investing in such deep value stocks. Buffett referred to them as "cigar butts," explaining that the idea behind this approach is to find a company that appears pathetic but is priced so low that there is still some value left in it, even if it's just one final puff. Despite the unattractive nature of these stocks, the bargain purchase allows for a potentially profitable outcome.

Unlike compounders, deep value stocks do not exhibit growth. Consequently, they are not intended for long-term holding but rather for selling when their prices recover. However, there is a risk associated with these stocks remaining undervalued for an extended period.

To mitigate this risk, there are two strategies that investors can employ. First, they can watch out for potential value-unlocking events that could cause the share price to increase. These events might include mergers and acquisitions, earnings turnarounds, or other catalysts. The market needs a reason to invest in these otherwise unattractive stocks. Second, investors can diversify their portfolio by purchasing a group of deep value stocks. With a sufficient number of stocks, some will likely experience significant appreciation in their share prices, offsetting those that do not move significantly and resulting in an overall positive return for the portfolio.

The third type of value investing involves purchasing cyclical stocks. These are typically companies, often related to commodities, that experience fluctuations in line with commodity prices. Examples include stocks in the oil and gas industry. However, investing in such stocks presents a challenge: their financial metrics tend to appear favorable during the peak of their cycle due to exceptional earnings. A low price-to-earnings (PE) ratio may deceive investors into thinking the stock is cheap, leading them to make a purchase. Unfortunately, they may later realize that they bought at the peak of the commodity cycle.

In such cases, it becomes crucial for value investors to accurately determine the stage of the cycle in order to make informed decisions. Ideally, they should aim to buy these stocks when they are near the bottom of the cycle, characterized by a gloomy outlook, rather than when oil companies are generating record profits. This allows investors to capitalize on potential future upswings in the cycle, maximizing the value of their investments.

It is crucial to recognize that there exist various styles of value investing, and understanding the specific type of value investing being discussed, as well as the type of value stock being evaluated, is essential. Failing to do so may lead to overlooking the relevant factors necessary for implementing a successful value investing strategy.