So is value investing all it's cut out to be?

Extract from Investopedia.com:

The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

Investopedia Says... The big problem for value investing is estimating intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value.

Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.

Source: http://www.investopedia.com/terms/v/valueinvesting.asp

Comments: So what is it about value investing that appeals? Essentially, value investing is all about finding discounts in the market and reselling the same product later for a higher price. Simple? Only if the markets were perfect - but if the narkets were perfect, then all companies would be fully valued and such "arbitrage" opportunities would not exist. So what then is value investing, and how can such an approach work for an investor?

1) A "value company" may or may not have future growth prospects - both are ok; of course, a company with future growth potential is better than a company without one. Even the subject of future growth potential can be sometimes a subject of controversy - quote, “I see little commercial potential for the Internet for at least ten years.” – Bill Gates, 1994. That is why traditional investors such as Warren Buffet stick to stocks whose companies produce products that they know well - of course this approach led Buffet to miss out on the Google phenomenon (but saved him during the dot com bust)

2)The company should be trading at a discount to its Net Asset Value. How much a discount and what assets to take into account is itself a challenge to define. The most conservative approach would be to take into account only the cash and near cash current assets (ie those that can be converted into cash easily like accounts receivables), and to leave out fixed assets and inventories (which although current assets, are less liquid) and less off all short and long term liabilities. The resulting amount, after dividing across the number of outstanding shares should give an investor a pretty good idea as to how much he would get back in a situation where the company shuts down and the proceeds distributed. These sort of companies used to be the target of corporate raiders in the past - of course depending on the float of the company, they might or might not be easily taken over

3) What is the trading volume like for the stock? If the stock is closely held, then its full potential is unlikely to be "unlocked", as larger investors such as funds avoid such companies.

4) What is the objective of the investor? To receive above average market returns in terms of dividend yield or to cash out on the intrinsic value when the market goes back up. This would help answer part of point 3).

5) Are you in it for the mid or the long term. If it is meant to be a long term investment, then some crystal ball gazing is called for. It might be easy to say now that computers, for example are in high demand today, but in the 1940s who would have known this? "I think there is a world market for maybe five computers." - Thomas Watson, chairman of IBM, 1943. One way would be to invest only in those industries that you are familiar in, but like Tom Watson and Bill Gates, even the industry insiders might get it wrong.

Happy investing!