There has been unprecedented market volatility in recent months due to the war between Russia and Ukraine, the US ripple effect, crude oil prices skyrocketing, and the risk of fiscal slippage. Adding to the woes of Dalal Street investors is the RBI tightening the money and increasing policy rates in the middle of rising inflation.
Does that mean that you stop building your long-term portfolio? Absolutely not.
The solution is in value investing.
What is Value Investing?
Benjamin Graham and David Dodd introduced the concept of value investing over a century ago. The original concept has evolved over the years. However, Warren Buffet and Charlie Munger truly popularised the idea.
Value investing is an approach to investment where investors identify stocks of companies that are trading below their market value. It means that the present market value of the share is less than its underlying value in comparison to its revenue and earnings from the business.
How To Build Your Long-Term Portfolio with Value Investing?
Valuations can be ideal for building a long-term portfolio – here valuation refers to a fair price of the shares. There are many strategies that you can apply to build a long-term portfolio with value investing.
1. Focus on Calculations and Not Speculations:
Agreed that your primary criteria for investing are the valuation. This does not imply that you only concentrate on that one factor and forget about the rest of the parameters.
The concept of value investing only works if it is based on the bedrock of detailed research and analysis. The focus should be to prevent losses whilst generating enough returns rather than picking investments that are high on risk and have little or no guarantee of any returns in the long term.
Briefly, valuation can be an effective starting point for your investments if it is qualitative, calculative, and even predictive but certainly not speculative.
2. Be Knowledgeable About the Intrinsic Value:
Most investors prefer to buy and sell investments basis their price movements only. Value investors, on the other hand, believe that the price of the share must align with its underlying value. In other words, the share price must match its intrinsic value in the long term.
Some ways can help prospective investors determine the intrinsic value of a stock.
You can look at the simple price-to-earnings (P/E ratio) that helps the investor know the price that must be paid for every rupee of profit. The ratio makes the calculation more relative; investors can benchmark the P/E ratio of the company against the industry in which it operates.
There are other more sophisticated models to estimate the intrinsic value of a stock. You can get the intrinsic value using the PEG (Price/Earnings to Growth) ratios, enterprise value to EBITDA (earnings before interest, taxes, depreciation, and amortization), the discounted cash flow method, and the replacement cost approach, the sum of the parts methodology, and more.
3. Ensure A High Margin of Safety:
When you value investing to build a long-term portfolio, you must consider a margin of safety.
The margin of safety is the difference between the current price of the share in the market and the intrinsic value of the stock. It gives investors the much-needed cushion or safety net if the assumptions about the stock’s future turn out to be grossly inaccurate from the original predictions.
A 30% to 60% margin of safety is the ideal scenario when selecting your long-term investments. If the estimates are accurate, the margin of safety also ensures a potential upside for the stock where you choose to invest.
4. Focus On Making Long-Term Investments:
Matching the price of the stock with its intrinsic value may be a work in progress over years. It does not always happen instantly as other factors come into play. It could be the general state of the economy, or the sector is out of favor.
Therefore, if you want to build your ideal long-term portfolio, then you must be patient and wait this period. It is the key to achieving success as a value investor.
What happens in this instance is that the market also gets adequate time to identify the actual value of the company’s stock.
5. Understand The Market Dynamics:
Investing without understanding the market dynamics goes completely against the fundamentals of value investing. Make investment decisions for short-term or long-term gains considering the current market conditions.
For example, if the market is optimistic, the stock may command a high price. On the other hand, if the market is going through a downturn, the same stock may trade at a much lower price. The investor decides what is the fair price of the stock and where to invest.
The idea is to be prepared to hold and not make any investments that may turn out to be unviable if the market conditions are going through a correction in the long term.
The Bottom Line
As an investor, you must focus on a value investing strategy that will help you create a long-term portfolio. It can include low earnings-multiple, net-net, and private market value that has historically produced outsized returns.
A combination of these proven value strategies amplifies the scope of investment, and you have a greater chance and opportunity to capitalize on market inefficiencies. Asset class diversification reduces risk without sacrificing returns and is the ideal route to value investing resulting in significant gains.
We hope this blog gives you a better idea of the intrinsic value of a stock. Would you like to build a long-term portfolio that is based on your financial goals and risk appetite?
Then subscribe to our 5 in 5 Wealth Creation Strategy and begin again.