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The Dos and Don’ts Of Value Investing

Value investors are, generally, people who are sceptical of complicated analyses that try to predict events far into the future.

As far as the value investor is concerned, the future is highly unpredictable.

The things that matters most to value investors is how to pick up a dollar’s worth of stock for less than 100 cents; limit the risks of buying the stock, and to wait for the market to acknowledge that it has made a mistake.

And here is the crucial part….they sell as soon the value has been sufficiently recognised.

They are not concerned with the yet-to-come because the value investor knows that it is highly uncertain. So here are some important dos and don’ts of value investing.

Do have a plan. It may come as a shock to even the most seasoned investor but there is no official definition of a value share. Value investors range from those who look for deep value to those who are happy with just a moderate degree of undervaluation. But you have to devise a cogent plan at the outset.

Don’t complicate things. In the main, a value share is one that is cheaper than its peers. The peers could be other shares within the same sector. It could be shares in the overall market. Keppel Corporation (SGX: BN4) might look cheap when compared to Singapore benchmark. But is it cheap? So how you choose to define the peer group is subjective. But whatever you decide, stick with it. Don’t change horses in mid-stream.

Do choose your fundamentals carefully. The market is awash with ratios that value investors could use to ascertain value. From something as traditional as Price-to-Book to more esoteric ratios such as Enterprise Value-to-EBITDA, investors are spoilt for choice. Sembcorp Industries (SGX: 96), for instance, is trading at a 20% discount to its book value. But is it cheap? Whatever you choose, be sure you understand what they mean.

Don’t be greedy. Don’t ask how much you could make from a share but how you could limit the downside. One of the hardest things to do in value investing is to define what is meant by “unreasonably” cheap. Singapore banks are trading below their historic valuations. But is DBS Group (SGX: D05) unreasonably cheap? Once you have defined the term “unreasonable”, then you have essentially cracked the secret of value investing.

Do minimise the downside. The key to value investing is to minimise the amount of money you could lose. You are unlikely to find too many shares in the market that will satisfy all of your value criteria. If you do, then chances are your yardstick for a value share might be too lax. So tighten it up. The aim is to minimise the downside by limiting the amount that a value share could fall further.

Don’t forget to read, read and read. The value of an undervalued share has to be discovered before it can rise. So spend time reading brokers reports. But be sceptical. Don’t try to look too far into the distance. Look only one year ahead.

Do look for yield. It could take a while before the market agrees with you that your chosen stock is undervalued. It might not even happen. So, whilst you are twiddling your thumbs, you want to be compensated for your commitment. A decent yield – especially one that is significantly higher than the market can be a good reward. It could also help protect the stock from falls.

Don’t ignore debt. Look for companies with little or no debt. If possible, look for companies that have cash or cash equivalents that exceed borrowings. A company might not be doing too well. But as long it has enough cash to meet its daily requirements then it is unlikely to go bust.

Do be contrarian. As a value investor, your role is to think differently. You cannot be a value investor if you are buying what everyone else is buying.

But simply doing the opposite to everyone will not always guarantee success. Only in certain circumstances will you be right. However, be conscious that occasionally the majority might be right and you are wrong. It can happen.

A version of this article first appeared in The Straits Times.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.