Value investing is a philosophy employed by some of the world’s richest investors.
Warren Buffett is a particular proponent, as is Terry Smith, the fund manager of Fundsmith. It puts forward the idea that there are certain fundamentals underpinning the success of the UK’s best companies, whether they are the smallest start-ups or part of the FTSE 100.
1. Take a long-term view
Value investing can make investors money if they buy shares in unloved companies with strong fundamentals.
While the market might correctly value a certain share, at other times, like just after a glowing trading update, the market may think extremely optimistically about the share’s future prospects.
At another time — and this is the time you and I are looking for — the market may have a very pessimistic view of the share’s short-term outlook, due to management problems, or struggles in some parts of overseas markets, or macroeconomic conditions that are not conducive to the business making lots of money.
At this time, the market will undervalue the shares, which is really when we want to buy them.
If we believe in the long-term health of the company, we believe the share price will rise over time, growing our capital. We’ll also take dividends as payment from the company for holding those shares in the meantime.
2. Focus on the fundamentals
When we say ‘fundamentals’, we’re really talking about the economic health of a business. This includes:
Profitability: How much profit did the company make last year? How does it compare to the amount of profit it made the year before? Are the margins increasing so each item sold is more profitable?
Revenue: Are the products that the company sells becoming more or less popular? Is the company leading the market or are its rivals beating it to sales?
Potential for growth: Is the business growing organically, or is it buying out profitable smaller companies and making their profits its own? What is the state of the market in the future?
3. Choose Main vs AIM
Financial mismanagement does happen at the biggest FTSE 100 companies. Remember the 2014 Tesco accounting scandal? That was a £250m black hole in the supermarket’s books, and one that raised questions about how such losses could be hidden by the largest British retailer.
More recently, famed short seller Muddy Waters attacked NMC Health, saying its research had revealed serious doubts about the profits, debts, assets and financial status of the FTSE 100 healthcare giant.
But in general, you may find the fundamentals of a company more difficult to determine in smaller companies with AIM listings, where they may have more opaque sets of financial records.
How so? Well, the AIM market as a whole has more lenient standards for financial reporting. For instance, they will find AIM-listed companies don’t have to have prior earnings records before going public, nor offer investors a prospectus that has been approved by the UK Listing Authority.
As such, and while I think there is significant potential there, I’ll be moving more of my focus onto companies listed on the FSTE Main Market in 2020.