(A) generates $100 per month & costs $500
(B) generates $50 per month & also costs $500
Would you rather buy a lemonade stand (A) that profits $100/month and costs $500 to buy or (B) that profits $50/month and costs the same?
Of course, (A) is better. This type of mispricing behavior occurs when an asset is traded for less than its intrinsic value or book value. Thus, value investing is the art of buying assets at a discount. In this example, stand (A) generating $100 per month is undervalued when compared to stand (B), because it generates 100%/$50 more revenue.
(B) generates $50 per month & also costs $500
Value Investing in Practice
Value investing is a concept that is inherent in all of us, but “the next big thing” causes us to abandon this mindset when it comes to stocks often because of fear of missing out or greed. We hear about that one guy that luckily bought Amazon back in 2001 but we never hear about the 50 other folks who bought unviable companies around that same time too. Our approach to investing is to invest where the data tells us to invest. With enough companies and time, things will hopefully work out. This model has been proven for decades.
Our position is simply to share with you the benefits of value investing so you can grow your wealth just like we have, without giving up unnecessary time.
Seeing It in Action
Let’s showcase that with dividing up the broad stock market. In the chart below, we take all the stocks and rank them according to how favorable they are, as measured by the following ratios:
Price / Earnings per share | Price / Sales revenue | Price / Free Cash Flow
The 5% most undervalued are displayed farthest to the right and the rest fall into fifth percentile buckets all the way down to the most overvalued. To compare, the broad S&P 500 is displayed farthest to the left. The chart exhibits the beauty of value investing; over the last 20 years, the SP 500 returned just 6.9% while investing in the most undervalued companies netted 17.7% annualized returns over the same time period.
Besides this one snapshot, we also would encourage everyone to look into the Fama-French Three Factor Model. This has been adapted by many value investors as supporting evidence that value and small-cap companies over time tend to outperform.
Finally, author, investor, and researcher Tobias Carlisle, of the Acquirer’s Multiple Website, Podcast, and ETF, has summed up many of the concepts we at Stock Mixology are (literally) bought into. We encourage all guests on our site to watch this video for a better understanding:
