Value Investing: Managing The Risks In Value Investing

Value investing, properly executed, is a low-to-medium-risk strategy. But it still comes with the possibility of losing money. This section describes the key risks to be aware of and offers guidance on how to mitigate them.

Basing Your Calculations on the Wrong Numbers

Since value investing decisions are partly based on an analysis of financial statements, it is imperative that you perform these calculations correctly. Using the wrong numbers, performing the wrong calculation or making a mathematical typo can result in basing an investment decision on faulty information. You might then make a poor investment or miss out on a great one. If you aren’t yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don’t place any trades until you’re truly ready. (For more on this subject, check out our Advanced Financial Statement Analysis Tutorial.)

Overlooking Extraordinary Gains or Losses

Some years, companies experience unusually large losses or gains from events such as natural disasters, corporate restructuring or unusual lawsuits and will report these on the income statement under a label such as “extraordinary item — gain” or “extraordinary item — loss.” When making your calculations, it is important to remove these financial anomalies from the equation to get a better idea of how the company might perform in an ordinary year. However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year, it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also beware a pattern of write-offs.

Ignoring the Flaws in Ratio Analysis
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. The problem with financial ratios is that they can be calculated in different ways. Here are a few factors that can affect the meaning of these ratios:

• They can be calculated with before-tax or after-tax numbers.
• Some ratios provide only rough estimates.
• A company’s reported earnings per share (EPS) can vary significantly depending on how “earnings” is defined.
• Companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same ratios. (Learn more about when a company recognizes profits in Understanding The Income Statement.)

Overpaying

One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer you pay to the stock’s fair market value — or even worse, if you overpay — the bigger your risk of not earning money or even losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.

Not Diversifying

Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and different sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.” Famous value investor Benjamin Graham suggested that 10 to 30 companies is enough to adequately diversify.

On the other hand, the authors of “Value Investing for Dummies,” 2nd. ed., say that the more stocks you own, the greater your chances are of achieving average market returns. They recommend investing in only a few companies and watching them closely. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.

Listening to Your Emotions
It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement may creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. You must remember that to be a value investor means to avoid the herd-mentality investment behaviors of buying when a stock’s price is rising and selling when it is falling. Such behavior will obliterate your returns. (Playing follow-the-leader in investing can quickly become a dangerous game. Learn how to invest independently and still come out on top in Logic: The Antidote To Emotional Investing.)

Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).

Basing Your Investment Decisions on Fraudulent Accounting Statements
After the accounting scandals associated with Enron, WorldCom, Tesco, Toshiba and other companies, it would be easy to let our fears of false accounting statements prevent us from investing in stocks. Selecting individual stocks requires trusting the numbers that companies report about themselves on their balance sheets and income statements. Sure, regulations have been tightened and statements are audited by independent accounting firms, but regulations have failed in the past and some unethical accountants have become their clients’ bedfellows. How do you know if you can trust what you read? (For more, see Enron Scandal: The Fall Of A Wall Street Darling.)

One strategy is to read the footnotes. These are the notes in a Form 10-K or Form 10-Q that explain a company’s financial statements in greater detail. The notes follow the statements and explain the company’s accounting methods and elaborate on reported results. If the footnotes are unintelligible or the information they present seems unreasonable, you’ll have a better idea of whether to pass on the stock. (To learn more, read Financial Footnotes: Start Reading The Fine Print.)

Sample Footnotes from Amazon’s 2016 Annual Report

Source: Amazon 2016 Annual Report, p. 68.

Not Comparing Apples to Apples

Comparing a company’s stock to that of its competitors is one way value investors analyze their potential investments. However, companies differ in their accounting policies in ways that are perfectly legal. When you’re comparing one company’s P/E ratio to another’s, you have to make sure that EPS has been calculated the same way for both companies. Also, you might not be able to compare companies from different industries. If companies use different accounting principles, you will need to adjust the numbers to compare apples to apples; otherwise, you can’t accurately compare two companies on this metric. (Learn about accounting standards and how to evaluate earnings quality by reading our tutorial, Using Accounting Analysis To Measure Earnings Quality.)

Selling at the Wrong Time

Even if you do everything right in researching and purchasing your stocks, your entire strategy can fall apart if you sell at the wrong time. The wrong time to sell is when the market is suffering and stock prices are falling simply because investors are panicking, not because they are assessing the quality of the underlying companies they have invested in. Another bad time to sell is when a stock’s price drops just because its earnings have fallen short of analysts’ expectations.

The ideal time to sell your stock is when shares are overpriced relative to the company’s intrinsic value. However, sometimes a significant change in the company or the industry that lowers the company’s intrinsic value might also warrant a sale if you see losses on the horizon. It can be tricky not to confuse these times with general investor panic. Also, if part of your investment strategy involves passing wealth to your heirs, the right time to sell may be never (at least for a portion of your portfolio).

Next, we’ll learn the names of some famous value investors and the strategies they’ve used to succeed.