Potential Red-Flags While Value Investing

We have discussed the basics behind value investing in past articles, as well as some of the World’s most famous value investors — Warren Buffet being a popular example. As a refresher, remember that value investing is all about bargain-buying stocks and getting in on an opportunity while the market price is listed below its intrinsic value. While this basic concept is simple, though, value investing can be complex because the term “intrinsic value” is so loosely defined.

For instance, even financial experts have come up with numerous definitions, some based on the price-to-earnings ratio and others around different growth metrics (as two examples). Additionally, today’s market has more influences than ever before thanks to increases in public awareness through varying forms of social media. As result, markets have become more volatile and values can shift significantly based off of large-scale public reactions — that are much easier to achieve now than ever before. As such, here are two things you might want to consider while purchasing stocks using a strategy that encompasses value investing techniques:

Pay Attention to Cash Flows:
As previously mentioned, value investors tend to focus a lot of their attention on profits or earnings figures. Generally, this is because profits are one of the main figures needed to use several of the most popular value investing ratios, such as price-to-earnings ratio, which was referred to above. However, it is important to remember that different figures can be used to provide different perceived outcomes. For example, free cash flow —as a metric — does not include any receivables or money owed, making it a truer representation of a company’s total liquidity. This is important because it could potentially show that a company might not utilize cash well, even with a track record of earnings. In that situation, the stock would likely not be a good value investment, despite the fact that it appears to be one using a single metric. Luckily, publically traded companies are required to provide cash flow information in their financial statements, so investors do have access to it and can make their own assessments. As always, it is important for each investor to do their own due diligence using the available data in order to make informed investment decisions.

Psychological Denial:
Sometimes, investors are their own worst enemy. Moreover, it is not uncommon for individuals to make a personal connection between their investments and their closely held self-image. As result, some individuals struggle to cut their losses while value investing because it can be difficult to admit that they were wrong and move on. While is it true that “riding the wave” or “cycle” of a company can turn around in an investor’s favor after it takes a negative downturn, as a value investor, you cannot rely on that to happen every time. Occasionally, companies fail to grow and an investor’s opinion regarding its intrinsic value was simply incorrect. Likewise, investors sometimes ignore companies that do not appear to be working out and let them sit in their portfolio slowly dwindling away. This is not a great strategy because there is no way of accurately reassessing the situation if the investor does not revisit the financial statements (or other previously used information) to determine if a new decision should be made. Consequently, instead of potentially discovering an incorrect assessment or major change since originally purchasing the company’s stock, the investor would be letting it sit unexplored and losing value.

Fortunately, it is absolutely okay to take risks and lose on investments sometimes. The main message that should be taken away this article is not to fear risk, but instead, to understand it and take the necessary precautions to limit your exposure to it. Naturally, there are no perfect ways to avoid risk, however, learning to control it is completely achievable! Similarly, not being happy about a loss is completely understandable, but the important thing is making the correct next steps to turn it around — or simply move on. By continuing to study and practice investing, you will undoubtedly be on the right track.