A value investor’s view
This article attempts to explain how value investors measure and manage their risk.
Risk is the potential to lose the principal invested amount.
Value investing is the school of investing thought that attempts to value and only purchase securities that are undervalued by the market.
Value investors measure risk by comparing the value of an investment with its price.
The starting point of any investment is establishing the intrinsic value of the asset.
This value is then compared to the price of the asset.
The closer the value of the asset is to its price, the riskier the investment becomes.
As value investing entails obtaining high returns with low risk, investments are made when the gap between the value and price of the investment is say at minimum 30%.
Risk is managed through obtaining as large as possible a margin of safety*.
The view in modern finance is that persons wishing to obtain high returns should take on more risk.
Taking on more risks means introducing a lot more price-volatility in their portfolio.
These companies share prices often fluctuate wildly due to their speculative nature.
These companies often have less than stellar recent profit records, high-debt levels ,are in highly-competitive industries...
In the old world they might have been called red hot penny stocks.
For people that don’t want too much risk,
They should not expect high returns and should put their money in bonds and only invest in index funds.
*Margin of safety is the positive excess of the value of the investment over its price.
Value investing sees things oppositely.
High returns can be obtained with low risk.
Take for example:
A company with average earnings of R5 per ordinary share and selling at R60; this is a return of 8.3%pa.
If for some reason the share price drops to say R45
but the company’s earning ability of R5 per share remains unaffected,
the share will now be generating a 11.1% return,
The principle here is:
the lower the price of a security becomes,
if the under-lying asset’s income earning ability remains unaffected,
the security carries less risk.
There is a joke doing the rounds that value-investors secretly wish for a financial crisis so that great companies like Apple, Shoprite, Coca-cola and Alphabet can be picked up at discount prices.
Prices drop for different reasons.
The Influx of money into new exciting industries and loss of interest in mature industries,
Financial meltdowns,
Company's recent trend of making losses,
Sudden public interest in Armageddon underground bunkers,
The plague…
Take for example the stock market of 2019 which favours tech stocks.
Too much money is being poured into technology, Unicorn IPOs and not much into mature industries like automobiles and food producers and others.
Stock prices are at the end of the day rules by the laws of demand and supply from economics.
Careful analysis can discover bargains in mature industries such as airliners, transport and others.
The whole concept of Value investing is about capital preservation.
A higher % return on your investment means that the company is making back your money quicker and therefore lesser risk.
Japhta Mamalema
21 Nov. 2019