Value Investing Workflow: The basic concepts

December 21, 2012

A workflow is a series of specific tasks or criteria that must be fulfilled in the course of reaching a larger goal. Our goal as value investors is to find, evaluate, purchase, and ultimately sell for a profit, the stock of publicly traded companies. There’s a series of steps required to be successful in this endeavor and the easiest way to approach the problem is by following a step-by-step approach, they can help you achieve the success you want in this endeavor. Following is the basic concept of a value investing workflow.

Step 1: Define company selection criteria

Value investors have a significant psychological advantage over investors following other strategies. Our task select companies where we are so sure about their underlying true value, that we have no hesitation about pulling the buy trigger when the price drops sufficiently below this value. This is akin to the dollar bill analogy I discussed in a previous post. Just as we know with 100% absolute certainty the value of a dollar bill, we want to be as certain as we possibly can on the value of the stock. The psychological advantage comes into play as the stock price of the company we are investing in drops lower and lower. As other investors are panic selling and writing off their investments as a loss, value investors are buying every chance they get, even as price goes lower. It’s a totally different feeling to actually hope that the share price of one of your investments goes down so that you can buy more! Having this mindset takes 99% of the fear out of making investment decisions.

While there are just too many variables at play to be 100% certain about stock value, we can put the odds in our favor by defining a strict selection criteria for companies that we wish to invest in. The criteria we use must take the following factors into account:

  1. Predictability – This follows the premise that companies which have behaved predictably in the past have a higher chance of predictable behavior in the future. Being predictable allows value investors to estimate key metrics such as earnings and growth rates with more accuracy, which in turn results in a more accurate stock valuation.
  2. Quality – As noted above, value investors intend to purchase more and more of a company’s stock as the price goes lower. It’s therefore vitally important that the stock price drop due to the market’s natural irrationality and not due to some underlying problem with the company itself! Part of the selection criteria needs to evaluate the quality of the company to ensure that there are no red flags with respect to the fundamentals of the company itself or its management.
  3. Industry knowledge – This one ties into the first two points, but it’s extremely beneficial (although not imperative) that the investor have a good understanding of the industry to which the company is a member of. This knowledge allows the investor to make realistic assessments as to both how predictable the company’s future prospects really are, and whether the company really is high quality or if management is just doing a good job covering up the underlying issues. It is therefore preferable to narrow the selection of companies to only those industries in which the investor has at least a working knowledge.

Step 2: Screen stocks against the criteria

With a set of defined stock selection criteria in place, it’s time to be put to use in an effort to locate suitable investment candidates. If the selection criteria is technical in nature, with specific requirements for EPS growth rate, market cap, debt ratio, etc., then freely available web-based stock screening tools are usually a good starting point. These tools accept the criteria you provide and output a list of stocks that meet the specified requirements.

The most popular free web-based stock screening tools are as follows:

If part of the selection criteria is more subjective / qualitative than can be defined by hard numbers, a good resource is to review some of the more prominent stock research sites. Articles are often biased towards the author’s personal investment goals, but can offer insights into aspects of companies that might otherwise be overlooked.

Some of the most popular stock research sites are as follows:

  • Seeking Alpha – I am a published contributor to this site and can speak to its quality and credibility as a resource for vetting potential investment candidates
  • Motley Fool – Their legion of “fools” write comprehensive articles that cover the full gambit of opportunities
  • Wall St. Cheat Sheet – Excellent commentary and insights
  • Investor’s Business Daily – Very much geared towards it’s subscription service, but offers excellent articles and research tools

Step 3: Read the annual reports

And the quarterly reports too for that matter. One of the key points outlined in step 1 was the advantage gained from being knowledgeable in the industry that the company belongs to. It’s also important to be knowledgeable in the company itself, and one of the best ways to do so is to read the reports put out by the company on an annual and quarterly basis. These reports can usually be found on the company’s corporate website, usually under a link called Investor Relations or often times just Investors.

While reading through the reports, value investors should concern themselves with any red flags that may affect the predictability or the quality of the company, as these will both be key to determining an accurate valuation in the next step. The reports are actually an excellent read as they are by law required to be quite forthcoming with respect to all perceived risks the company faces, it’s position with respect to competition, any legal actions against the company, areas of growth, etc. Also included in the reports are the financial statements which should be reviewed as well. Any companies that raise too many red flags should be disqualified from further review.

Step 4: Determine company valuation and confidence level

At this point, the value investor should have a small list of highly predictable, quality companies which have been vetted individually through online research and a review of it’s recent reports. These should all be companies that the investor would be comfortable holding for the long term and would not hesitate to buy, especially on a declining stock price – assuming that it is selling for below it’s true value.

And that is the next step – to determine the true values of the companies we’ve narrowed our list down to. There are many methods of determining company valuation, and these are the subject of other articles. The important thing is that a value be determined on a per share basis so that it can be easily compared with the current trading price. In addition to determining each stock’s true value, a level of confidence must also be assessed. For example, we may determine that we believe company XYZ to have a true value of $60 per share, with a confidence level of 80%. This again goes back to the concept that the valuations we calculate are only an estimate. As such, we can never be 100% certain that it is correct. Therefore we assess a confidence level for each stock in our list and deal with the inherent uncertainty in the next step when we determine the entry price.

Step 5: Calculate margin of safety and entry price

We now have a true value for each stock that met all of our selection criteria – or at least a pretty good estimate of true value. But how do we deal with that uncertainty that our true value is correct? We certainly want to avoid a situation where we calculated a valuation of $50 / share for company XYZ, start buying it in earnest at $45, when in fact it’s true value is only $40! We address this uncertainty in our value calculation by means of a margin of safety. Instead of simply buying when stock price is less than it’s intrinsic value, we buy at a discount to the calculated value, hence building in some cushion in case we are incorrect.

The concept of a margin of safety is more clearly illustrated by example. Let’s continue our look at XYZ company and assume again that we calculated an intrinsic value of $50 per share. We’re perhaps only 70% confident in our calculation however and must apply a margin of safety to provide some protection against this potential inaccuracy. The amount of safety margin to apply depends on both the confidence level we have in the intrinsic value, the investment strategy being employed, and the investor’s tolerance for risk. Let’s say in this case that we are extremely risk adverse, and apply a margin of safety of 30% to this stock. Our target entry price would therefore be calculated as follows:

  • Entry Price = (Intrinsic Value) – (Margin of Safety * Intrinsic Value)
  • Entry Price = $50 – (30% x $50)
  • Entry Price = $35

In this case, the margin of safety would have provided protection against a situation where the actual intrinsic value was $40, as we wouldn’t begin buying until the price drops below $35! The downside to large margins of safety is that it limits the entry opportunities available, particularly if the value calculation is accurate. It’s not every day that excellent companies sell at a discount of more than 30% of their intrinsic value. There’s a balance that must be made between risk and opportunity.

Step 6: Develop and maintain a watch list

We now have a list of stocks complete with a solid valuation and target entry price attached. We must now monitor our list on a regular basis by means of a watch list. A watch list can be as simple as a list on paper, but is typically more practical these days to use a web-based service. I personally use an excel spreadsheet that incorporates a data feed to update price and other stock metrics automatically for my calculations, but that is the other end of the spectrum. It’s sufficient for most investors to simply use a free service such as that available on Seeking Alpha.

The watch list should be monitored for two purposes. Firstly, we must watch to see if any of our investment candidates drop in price to below our target entry, which would be a signal to buy and will be covered in step 7. We must also monitor the stocks in our list to ensure that they continue to meet all of the criteria that allowed them to make the list in the first place! A periodic review of the company’s financials, quarterly reports, and the rest of the criteria developed in step 1 must be made to ensure that the company remains predictable, high quality, and generally suitable for our investment strategy. Any stocks that fail this test should be removed from the list.

The frequency that the watch list is reviewed depends greatly on the strategy being used. For most strategies a daily review of each stock’s trading price in comparison to the target entry price is sufficient. On a weekly or monthly basis, a more in depth look should be made at each company on the watch list to screen out stocks that are no longer eligible for the strategy. On a quarterly basis new screens should be made to add any new candidates to the watch list by following steps 1 – 5 again.

Step 7: Position entry

Eventually one or more stocks in our watch list will trade for a price below our defined target entry price. Our entry strategy could be as simple as to invest all available capital in a lump sum purchase, but this is probably not wise. There are various considerations that need to be made, and defined in a position entry plan:

  1. Percentage of overall capital to allocate to each stock. There are many differing views on proper diversification, but it’s generally not good to have all of your eggs in one basket. Spreading available capital over a total of five stocks is generally regarded as the absolute minimum, with most experts recommending 15 – 20 securities in a healthy portfolio.
  2. Timing. Most strategies dictate that a purchase should be initiated as soon as a buy signal is achieved, however other criteria could also be applied such as using technical analysis in an attempt to time entry, waiting for a support level to be reached, etc.
  3. Position Sizing. Position sizing can also be tailored to the strategy – one option is to simply invest the entire allocation determined above in a single trade. Other options might be to only invest a portion (say 25%) of the allocated capital in an initial trade, and then to buy more as the stock price moves lower, or at a fixed time interval. One more alternative is to apply Wyckoff method.

Step 8: Position management & exit

Until now all of our attention has been focused on proper selection, evaluation, and initiation of a position in an investment. Proper position management as well as having and following through on a proper exit strategy is important in ensuring that each investment has the highest probability possible of resulting in a profit. It’s critical that position management rules be defined up front, prior to the purchase of any stock. Greed is just as dangerous as fear in the investment world, and it’s all too easy to watch an investment climb higher and higher to a huge gain, only to watch it drop back down again to the initial entry price (or lower!) without ever pulling out a dime of profit.

Value investment strategies all base entry conditions based on stock price being lower than a calculated intrinsic value. It only makes sense then that a suitable exit strategy might incorporate some criteria of the stock trading at or a percentage above it’s intrinsic value. This isn’t the only option though. Investors for example could combine a value based entry with a buy and hold approach, holding stock for the long term. Time based approaches, or an exit based on macroeconomic events could also be used.

Applying these steps to the real world

In this article we’ve identified a solid workflow for the development of a profitable value investing strategy. I have broken the workflow into steps for a reason. There are many different ideas and strategies and criteria that can be applied to most of the steps, and we’ll explore these separately in other articles. We can then mix and match strategies for each of the steps to create several overall master plans! For example we could keep the same stock selection criteria, but experiment with different entry and exit strategies. Or we could define a buy and hold approach, but use an extremely complex stock valuation system. There are thousands of possibilities and we will explore and evaluate the best ones here on Stockodo!

7 thoughts on “Value Investing Workflow: The basic concepts

    1. Thanks Marvin! Yes, I find if I try to develop procedures to follow, it helps me stay on track. Not always easy as there’s some art to investing – not just science. Thanks for the comment 🙂

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