Value Investing for Beginners

Writing this on 30th of December 2020. I’m up 125% in the past 6 months.

You don’t need an MBA to learn investing. But you do need a strong interest and some time on your hands.

Here are some lessons I’ve learned and how I’d teach Value Investing for beginners, after more than 10 years in the game:

The Fundamentals:

• 1) Valuation is #1: The price you pay determines all future returns
• 2) Valuing Stocks: Valuation metrics, DCF-analysis, relative valuations
• 3) Risk-Reward: Guesstimate the Expected Value
• 4) Portfolio Construction: How many stocks to own?
• 5) Work Process:  Screening, Valuation, Watchlist
• 6) Opportunity Cost: Concentrate on your best investing ideas 
• 7) Top Valuation Metrics: RoE, ROIC, EPS, EPE, EY, FCF, Solidity
• 8) Soft Factors & Business Strategy: Good Industry, Leader, Niche, Value Chain, Business Model, Best Customers
• 9) Psychological Resistance: Don’t run with the herd just because it’s easy, and beware of anonymous accounts on social media

If you have talent for investing, it will show. But not effortlessly. You have to put in the work. And you need to put your money on the line.

If you have talent for investing, it’s a hobby that pays off and well worth the intellectual work required.

If you don’t have this talent, but you’re interested, you can still make up for it over the long-term. But you will make more mistakes.

If you have neither talent nor interest, you should not get into investing. Nor trading or other speculative games (which are far more competitive).

Now for the Tips. 

Investing is best learned by doing—

–not by reading or listening to podcasts.

Put your money where your mouth is and learn from the feedback of gaining or losing money.

Value Investing for Beginners

#1: Valuation is the most important thing

Price is what you pay, Value is what you get. 

Everything is a buy at the right price. . . 

Question is: Can you say when?  Can you find such an opportunity before others do? 

This is the question.

At EV/EBIT 30x you need to be extremely sure in your analysis, and P/B 0.1-0.4 often means it’s a crap business.

In my opinion, most people are not selective enough about the valuation.

They are willing to pay a premium for stocks that don’t deserve it (because they heard it from someone else and were too lazy to think for themselves, spending too much time on Finance Twitter or Finance Forums, trying to gauge what’s popular instead of doing the work).  

How to value stocks?

It’s all about guessing the future. The most popular versions are:

• Valuation Metrics
• DCF-Analysis
• Relative Valuations

Valuation Metrics = Divide the Market Share or Enterprise Value by different operating metrics such as sales, profits, cash flows, dividends, etc….  P/B, P/E, P/S, PEG, EV/EBITDA, EV/EBIT, P/FCF, P/Y, ROE, ROA, ROIC…

DCF Analysis = Discounted Cash Flow Analysis = Calculate the value of the stock by discounting all of its future cash flows (set to an arbitrary end year) by its risk-premium. The easiest way to choose an appropriate risk-premium is by using your closest alternative cost or by setting an arbitrary number equal to your minimum acceptable return (e.g P/E 10).

Relative Valuation = By far the simplest. You just compare the valuation metrics to its peers. Since this is easiest, it’s also most often misused and misinterpreted. To use it, you need to be able to synthesize the information from multiple valuation metrics, not blindly focusing on just one metric. 

In my opinion, Relative Valuation has become over-used.

#2: Risk-Reward is what matters.

Even if you have a good valuation you feel certain about, you need to consider the risks involved. What’s the probability of being right?

Everything is a risk-adjusted bet.

What matters is not the potential, but the Expected Value. 

Theoretical Example:  

Which one would you go with? Maximum 5 seconds to think.

Stock 1:   10% chance of 20x return = 200%

Stock 2:   80% chance of 40% returns = 32%

Stock 3:   60% chance of 3x returns   = 180%

In this case, Stock #1 has the highest expected value, so it’s your best choice.

But since it’s only 10% chance, you wouldn’t dare to put all your money into it, since you will lose 9 times out of 10.

However, IF you had the ability to make ten bets like that, you would gain 200% by mathematics.

Unfortunately, you almost never have 10 choices like that. So maybe you would only dare to put 10% of your money into it. Whilst putting most of your money into Stock #3, with a solid 60% chance of 3x returns. That’s something you should dare to bet heavily on.

It will never be as simple as this, but that’s how you should think.

#3: Portfolio Construction:

How many stocks to own?

There is no Right Answer.

 It depends on how much money you have and your ability to bear risk. 

A good rule of thumb is around 7. Seven stocks to spread your money across. Less if you are confident you have an edge. Never above 15.

If you were to manage someone else’s money, you absolutely don’t want to lose it. This is why funds are always extremely diversified in their holdings. It’s considered concentrated for a fund to have more than 5% in one stock.

Your biggest advantage over big funds is that you can hold a more concentrated portfolio.

So: The easiest investing strategy is to find a good fund, take their 5 best stocks, and only own those stocks.

This will give you better returns than owning the fund, for free. 

#4: You need a work process 

There are different ways to work with stock analysis. Let’s focus on these:

• Screening
• Valuation
• Watch List 

Screening means you are using a Stock Screener (program to find stocks based on arbitrary criteria).

Valuation means doing the analysis to decide whether the stock is undervalued. This relies on valuation metrics.

Watch List means saving & prioritizing your investment ideas. It’s important to be disciplined. Otherwise you will forget your ideas. Everything is a buy at the right price…. The point with a Watch List is to return to it every once in a while in hopes of a bargain.

#5: Always factor in opportunity cost

If you have 5 choices, and two are superior, the remaining three are irrelevant. 

Your Watch List may contain 100 stocks, but if you can’t easily tell me which are the top 1-10, you suck. It shows you have not thought hard enough and have no good way of prioritizing your ideas. 

To summarize this section:

• Valuation 
• Risk/Reward
• Power Laws

If you can internalize these ideas, you will be well on your way. 

The Most Important Valuation Metrics

This next piece of advice of Value Investing for Beginners will focus on:

Screening to find high quality companies and having some common ground for comparing them on a basis of Value-to-Price. 

What matters is understanding what these metrics say; the story they tell, and what their combined power accumulates into.

The most important valuation metrics:

1. RoE = Return on Equity = The % of profits you (as a shareholder) get. 
2. ROIC = Return on Invested Capital = The % of profit divided by capital used in the business. If a business can maintain a ROIC above 20% for many years, it has a competitive advantage and/or dominates a niche. A High ROIC means the business model may be scalable. The highest ROICs are currently in underappreciated advertising vehicles.
3. EPE = Earnings per Employee = if they make a lot of money per employee it could be a scalable business model. 
4. EY = Earnings Yield = EBIT/EV = Profit before interest and taxes divided by enterprise value (Market Cap + Debt – Cash). This tells you how much the business is earning (with relation to leverage).
5. EPS = Earning per share = how much profit you (as shareholder) get per share. You want a rising EPS, because it shows that the company is creating shareholder value. Beware of companies with decreasing EPS. Lots of people are currently dumb enough to disregard this. Don’t be one of them. When this happens, it means (a) the company is screwing you, or (b) they are making a tradeoff for the long-term that will pay off in 1-2-3 years. And if so there should be a BIG FAT explanation, now. Never pay a premium for one of these companies. 
6. FCF = Free Cash Flow = The business is generating more cash than it takes to operate. Low or negative FCF is fine if it’s a growth business
7. Solidity = Equity/Assets = how much of the business is financed with shareholders money, as opposed to debt. 8 times out of 10 you want a high solidity company because it means the risks are lower and you can sleep without worrying at night. 

Know these and know them well and you have done half the job!

if I had to only choose 3, it would be ROE, EPS and EY. 

Now for the soft factors

The soft factors are things not as easily quantifiable, but perhaps more important. People say Value Investing is dead (by which they mean it’s extremely hard to find Net-Nets, forced liquidations, and special situations as a retail investor).

That said, here are some important soft factors in evaluating a business: 

1. Good Industry:  You want an industry benefited by global trends. The reason people like Tech Stocks is because it’s a great industry. Some companies are overvalued, but as a composite, Tech is gaining momentum and market share.       
2. Leader:  If possible, you want to bet on the leader. Preferably without having to pay a big premium. But that’s rare. Unless the Leader is totally dominant, it’s typically better not to buy it. You’re better off finding a high quality peer with a low relative valuation. In terms of leadership, there are at least three ways to look at it: (i) Herfindalh-index for big industries, (ii) Relative market share, and (iii) Star Principle (business at least twice the size of its closest competitor in revenue, in a high-growth field). The question remains: How much of a premium are you willing to pay for continued growth?  This is the most difficult and important question. It presupposes two parts: How long and at what growth rate?   
3. Niche: The easiest example is a premium brand that has kept up for more than 30 years. Like Hersheys or See’s Candy or Disney. Arguably, these have grown too big nowadays to be called “Niche”, but they started out that way and sustainably grew over decades without losing their core base. Which, in itself, is impressive. With the birth of the Internet and social media, Niche-formation (AKA: segmentation) happens faster and faster.
4. Value Chain:  Who’s cutting out the middleman? The reason most Newspapers and media companies can’t keep up is because the competition went up too fast. But YouTube, Google, and Facebook (that are selling shovels to the gold diggers) are profiting handsomely.  And so are Niched Publications (Law, Science) and specialized SaaS companies. Why is that? Because the average person cannot easily displace them through social media.
5. Business model: Some business models are better than others. It’s true that everything is a buy at the right price, but most of the time, the lines are blurred and it’s easier and more cost-effective to stay away from horrible capital-intensive businesses. Look for companies with a scalable business model, or one that has moderate growth but extremely good and sustainable returns (EPS, ROIC, ROE). Over most of the 20th century, this was premium consumer brands. Going into the next 10 years, the equivalent will most likely be cyber security companies and VPNs with sticky customers, able to expand their line of products or raise the price of the subscription each year.
6. Best customers: Examples are in credit services, casinos, online trading services, and mobile games. These are all (theoretically) competitive fields, because there’s not much of a difference in the services rendered. Therefore, the edge becomes who can get the most stupid customers and (a) get them hooked, (b) convince them that their service is superior to the rest.  And of course this will result in more money because they will spend more on average. And the company can use that surplus for advertising. CAC › LTV.

These ideas belong more in the realm of Business Strategy than investing or corporate finance. But it’s something you should definitely know in terms of value investing for beginners.

Recommended Articles:

I’ve written two relevant articles on this subject that you may want to read:

• (a) Two Investing Approaches: Betting on, or against, Homeostasis

VC-approach: Bet on change. High risk, high reward, super scalable tech business with something completely new or 10x better than its closest established incumbent. Very hard.  

Buffett & Munger style investment: Avoid change. Find quality businesses you can keep “forever”. Like a longer-term version of the Magic Formula.

• (b) The Key to Success is to Be in the Right Business

On the importance of fishing in the right place. Spend your time analyzing companies in fast-growing and/or highly profitable areas.

Psychological Resistance

A Value Investor must not get suckered into the latest fad.

This requires some degree of psychological resistance.

It’s easier if you can internalize these ideas:

1. On Twitter and social media, 80% of accounts are fake 
2. Don’t trust anonymous accounts 
3. Only absolute returns matter, disregard 1-year returns unless extreme

On the other hand, if the market remains as per 2017-2020, being first to jump into the next bubble is what pays off best.

Social Media:

I don’t believe it’s healthy for ppl under 25 to use social media. 

Especially not as a vicarious spectator. 

If you are older than 30 and more rational, perhaps you can use this to your advantage. 

Don’t take tips from a stranger. That’s how you get in danger. 

Especially if you’re trying to fit in with a crowd of anonymous accounts. 

Envy:

Someone will always do better than you. 

Don’t focus on that.

Focus on what would make a meaningful difference for you. 

Summary: Value Investing for Beginners

These are the 9 Fundamentals

Good luck investing.

Read this too:

5 Investing Methods that have Consistently Beat the Market

And if you are Swedish, check out:

Finanskursen.se