This article on how to start value investing was written by Evan Bleker. Evan, a private investor since 2002, is also founder of Broken Leg Investing & Net Net Hunter.
Decided to start value investing?
Congrats. Most people stumble through investing, oblivious to the fact that value investing is the most reliable way to crush the market long term. Most are busy trying to buy hot growth stocks or trade based on market news. This is a losing proposition that costs investors billions of dollars a year.
So, your decisions to switch to 'the winning team' is a wise one, even if it may be late in the game. But, now that you've decided that value investing is for you, how do you begin? What's your first step? What's the process like?
I have those answers for you below. And, while I'm more than happy to share my experience as a professional value investor, I'm not going to sugar coat the process for you. What follows is the complete no-bull guide you need to start value investing… and thrive at it.
My Painful Attempt To Start Value Investing
I began value investing in 2001 but it took 10 long years to find my footing as an investor and finally start earning excellent returns.
I had spent the previous 12 months slaving away at a fibreglass ship yard carrying 100s of pounds of plywood up flights of stairs day after day, sweating, fibreglass dust embedded in my skin. You should try it. Nothing will make you work quite as hard to improve your economic life.
My goal was to save enough money to buy a beautiful read Jeep Wrangler. By the end of the year I had enough to buy the truck outright, in cash, but I knew that the pain and suffering I'd been through was not worth it. I knew I had to put my money to work for me, instead.
The bank's financial advisor wasn't at all interested in helping. While on the phone, she slid a laminated piece of paper across her desk towards me showcasing the mutual funds she wanted me to buy. Even back then I realized how terrible of an investment these were - many were stumbling their way along the bottom edge of the chart and some were even losing money. It was at that moment I knew I had to take full control of my investing if I wanted to earn decent returns.
I stopped at the library and loaded up on investment books then began pouring through them, soaking up as much information as I possibly could. Some say I went a little crazy. I would spend lunch breaks, evenings, and weekends buried in books, taking detailed notes. I eventually enrolled in economics, accounting, and other business courses hungry for more.
A few years into my initial deep dive, I began putting down my own money on actual stocks. Lacking the big picture knowledge critical to successful investing, and stymied by the enormous amount of work it took find decent stocks to buy, I wandered from strategy to strategy for nearly a decade. It was an tremendously frustrating experience.
In fact, I was going to give up investing entirely and just buy a couple of low cost index funds but then a few concepts finally clicked into place. I began to see the matrix, if you will, so shifted my focus to what I now call Broken Leg Investing.
You do not have to embrace Broken Leg Investing to use this guide. Far from it. My only hope is that you avoid a lot of the painful twists and turns that I encountered during my lost decade as I tried to find my way.
Your Best Value Investment Is Knowledge
You've heard all the cliches about knowledge being power. Well, they're absolutely true.
Every year thousands of would-be value investors start trying to pick their own stocks without having the requisite background knowledge or mental scaffolding. It's insanity.
As I write this, 10s of thousands of MBAs from prestigious universities are hunched over spreadsheets, combing over financial statements, reading proxies, and putting together industry reports. How many of them do you think beat the market long term?
Next to none.
And neither do most small private investors. In fact, many significantly underperform the market long term.
So, how do you expect to beat the market yourself without acquiring the needed knowledge and mental frameworks?
Before you let this deter you, let me just say that you don't need a Harvard MBA to earn exceptional long term returns. Professional investors on Wall Street face significant institutional constraints (portfolio size, peer pressure, investment style restrictions, etc) that makes investing difficult. You don't face those same challenges, and you're already ahead of the pack versus "the average investor" having adopted value investing. But that doesn't mean you can just wing it …you definitely need knowledge.
Knowledge comes in two broad flavours: tactical and strategic.
Tactical knowledge is what most value investors focus on. It's the knowledge of how to place a trade, how to calculate a PE Ratio, what sort of red flags to look for on a company's Balance Sheet. These are all critically important, but investors routinely gloss over acquiring equally critical strategic knowledge.
Strategic knowledge is big picture knowledge. It goes far beyond which "value investment strategy" you plan to use. If tactics are an individual World War Two battlefield, strategic knowledge is the bird's eye view of Europe, where armies are located, strengths and weaknesses of the enemy, and where to gain access to resources. This sort of knowledge is critical because, just like an individual battle is only relevant within a larger strategic picture, the tactics you employ in investing have to be based on an overarching strategic framework.
If I've done well in investing it's only because this framework suddenly clicked into place 10 long years after I started value investing. I was lost, drowning in tactical knowledge, before then. Click here to download our free investment guide.
Unfortunately, little is written on this knowledge because book publishers know that investors prefer to read about tactical knowledge and investment strategies. This is why I wrote Portfolio Construction 101 for The Broken Leg Investment Letter subscribers. There just wasn't anything else I knew of that pulled together these critical ideas.
If you're not a subscriber, you can also check out Contrarian Investment Strategies: The Next Generation and Thinking, Fast and Slow. While not perfect, they are the best I've found.
Start Value Investing With These Books
If knowledge is your most valuable investment when you start value investing, this section is your treasure chest. I've found these books exceptionally valuable and highly recommend them when starting out.
Remember, though, that this list is just a start, your first introduction. Becoming a decent value investor means internalizing a huge body of information and important ways of seeing the world.
Buy, read, study, and memorize the lessons in these books in this order:
- The Neatest Little Guide to Stock Market Investing by Jason Kelly
This book is the absolute beginner book so perfect if you want to start value investing. It will walk through what a company is, what a stock is, what a stock market is, how you buy and sell stocks, what financial statements are, provide a detailed description of each statement, and provide a wide range of basic must know financial and investment ratios. This is highly recommended for someone without a background in finance or investing and who is new to stock market investing. Highly recommended.
- Contrarian Investment Strategies: The Next Generation by David Dreman
David Dreman is little-known Canadian superstar investor. He earned returns better than Marty Whittman and is neck in neck in terms of alpha with Charlie Munger. His approach is as simple as it gets and in this book he gives a fantastic overview of mechanical investing before it was called that. He’s a “Contrarian” and his book will show you how well contrarian portfolios do through charts and statistics, and in all sorts of market situations.
- Thinking, Fast and Slow by Daniel Kahneman
A Nobel Prize winning behavioural economist shares the result of his life work in a non-academic best seller. You learn basic problems with human information processing, systemic mistakes we make when reasoning, and are shown why it pays to focus on developing a good investment process. The best book I read in 2015.
- Financial Statement Analysis and Security Valuation, by Stephan Penman
A detailed guide to understanding financial statements for those without a financial accounting background. Knowing accounting is a must and trying to be an investor without knowing accounting is like trying to be an author without knowing how to read.
- Frenzy by Carl Haacke
A solid look into the anatomy of the growth, bubble, bust, recovery cycle and how these regular market cycles trip up investors. Understanding the big picture in investing helps you maintain a long term view of the markets and what happens to your portfolio. This is an absolute must read.
- The Little Book of Behavioural Investing by James Montier
Your introduction to the behavioural aspects of investing. The psychology of investing, emotional intelligence, or investor temperament are all terms for the same thing: having a strong stomach and avoiding psychological traps. You can have an IQ of 200 but it won’t mean anything if you haven’t cultivated the emotional temperament to do well as an investor. Ignore this and you will fail to invest well over your life.
- Emotional Intelligence by Daniel Goleman
This is a great book to help you develop your emotional intelligence. Understand how you feel, what triggers those feelings, and how you are likely to react due to those feelings. Goleman’s book is both theory and practical steps that you can apply in your own life to sharpen your EQ. A fundamental book.
- Influence by Robert Cialdini
A more specialized book, Cialdini looks at the psychological traps that people stumble into and marketers use to lead you astray. A lot of the tips or tricks in this book leverage basic failings or automatic systems in human psychology. Not just useful for understanding marketing and sales, this is also a very powerful body of knowledge to have as you approach investing.
- One Up On Wall Street by Peter Lynch
The King of Qualitative. Lynch was an investment phenomenon and earned a return of 29% over a ten year stretch through a range of different strategies, most of which were based on a qualitative “trader-like” look at investing. If you want to boost the quality of your stock pics above a quantitative portfolio, this would be a great place to start to look.
- Beating the Street by Peter Lynch
The followup and just as great of a read as the first book.
- Snowball by Alice Schroeder
This is the definitive guide to Warren Buffett’s life. Understand how he earned the returns he did and how his focus on returns throughout his life destroyed his family. Aside from the great moral lesson, this book provides a solid overview of Buffett's transition from Classic Ben Graham value investing to his contemporary style.
To Start Value Investing You Need To Pick An Investment Strategy
Before you can start value investing, you have to pick a strategy. I struggled for ten years trying to find a decent strategy to use. It almost killed me. Now, 17 years after I started value investing I've come to realize a critical mistake I made.
The world of investing is full of sales people an con-artists. There's a lot of money to be made when it comes to investing someone's life savings. There are all sorts of websites, publishers, authors, and brokers trying to make a buck off of your future. Even your bank's financial advisor wants to grab a piece of your retirement funds.
I learned this lesson the hard way. While I was smart enough to tell that my bank's financial advisor was just trying to push her employer's mutual funds, and didn't actually care about my finances, I soon slipped into another trap.
The trap was skillfully laid in Jason Kelly's book, The Neatest Little Guide To Stock Market Investing. While Kelly's book is an absolute must-read for anyone before they start value investing, Kelly himself seems to have fallen prey. I began following the writings of a couple financial gurus who seemed to have a great track record. I began structuring my portfolio the way they suggested and picking the stocks that fit their model.
In a year's time I began to watch my portfolio tumble. It was only then that I began asking questions. How good were these guys anyways? How useful was a company's "funny advertising" in determining its investment merits? As it turned out, more and more people online were asking the same questions and it wasn't long before I realized that the pair were better marketers than investors.
I quickly lost 1/3rd of my investment portfolio.
The devastating mistake I made was failing to select an investment strategy based on solid long term investment returns as shown by both academic studies and use in practice.
Both are key. Actual studies and backtests should be the foundation of your investment strategy. It's incredibly important to use a strategy that is supported by solid evidence when you start value investing. There are all sorts of investment strategies out there and marketers make all sorts of claims about performance but academics help cut through the noise because they're primarily interested in producing high quality research that will pass the scrutiny of their peers. No other group of men (and women) can verify or disconfirm a strategy's efficacy as well.
But your strategy also has to be able to be used in practice by real live investors. All the academic research papers in the world highlighting the great returns of an investment strategy are worthless if it's impossible to actually apply the strategy in practice. This is why you have to find practitioners who have actually used the strategy successfully to produce their own outstanding record.
This is exactly why I adopted Ben Graham's classic net net stock strategy for my own investing. It's also why ultra Low Price to Book and Graham's Simple Way strategies lay the foundation for out strategies in The Broken Leg Investment Letter.
Other strategies do exist, and you would be wise to explore them before you start value investing. Start by downloading Tweedy, Browne's What Has Worked In Investing. It's a great investment guide exploring many value strategies over a number of decades.
One last word on picking an investment strategy: When you start value investing, make sure you decide on a strategy known to produce very large returns because you're bound to make mistakes. These high performance strategies make it much more likely that you'll beat the market and avoid losses.
Quickly Master These Three Areas After You Start Value Investing
Being a value investor means being a life-long learner. There's always something more you should know.
I recommended a good number of books for you above, but if you want to start value investing then you have to be prepared to dive deeply into three key areas.
The first area that you have to become an expert in is your chosen strategy. A lot of practitioners recommend being flexible and shifting between strategies to "hunt for value wherever it may be". These same practitioners are also approaching value investing from the perspective of someone managing billions of dollars. If you're managing less than $1 Million, there's always a good value stock to buy that fits your chosen strategy.
There are major advantages to sharpening your focus and diving deeply into a single strategy. Specialization is the mark of an advanced civilization …and for good reason. Do you want the same guy who came in to fix your plumbing to look at pulling your wisdom teeth? Specializing in a single area helps us build an incredible amount of skill in one area and perform at a much higher level. Click here because we provide insight into the highest performance deep value strategies.
Once you decide on a particular strategy, you should spend a significant amount of time reading academic papers on the strategy, understanding how the strategy performs from year to year, and how to optimize your own behaviour to achieve the best outcome.
Academic papers are, again, a great resource. Comb through a lot of academic papers on your strategy, record the process used to obtain the author's results, and note a lot of the finer details on how stocks were selected. I've spent a considerable amount of time reading through academic studies to determine which stocks I should exclude from my portfolio, which stocks produce the best returns as a group, and even how long I should hold onto my stocks for.
Become an expert on your chosen strategy.
If you're ready to start value investing, you should also heed the advice Buffett gave in one of his shareholder letters: "Accounting is the language of business."
Being a good value investor means having strong competency with financial accounting because most of a value investor's decisions are based on a company's financial statements. Financial statements tell investors what's happening at the company, how the company is performing, whether a company is at risk of bankruptcy, if there may be significant undiscovered pockets of value, and even if management may be crooks.
Understandably, it's vital to get a good grasp of financial accounting if you want to earn great long term returns. You wouldn't expect to become a great writer without learning grammar, or a great mechanic without learning how an engine works. Why would you think you could become a great investor without a solid understanding of accounting?
Finally, developing your emotional temperament is fundamentally important if you want to start value investing. Ironically, it's also an area that most guys make sure to avoid. Maybe this is why they lose so much money.
You may know emotional temperament better as emotional intelligence, or EQ. Emotional intelligence is the ability to recognize what you're feeling, understand why you're feeling that way, and predict what you're likely to do as a result. As soon as you realize that much of human behaviour is driven by emotion you begin to realize just how vital this area is.
In fact, research into this area has ballooned since the mid-2000s. Even the field of economics has been effected. While once economists believed we were cold, hard, utility maximizing machines, increasing evidence disconfirming these theories forced a shift towards behavioural economics. This new economic paradigm leans heavily on human psychology and emotion while making decisions.
Emotion, as it turns out, causes people to do all sorts of whacky things, such as buy hot stocks or sell all of their holdings during the depths of a dark bear market. Sure, you can ignore developing your emotional intelligence, but it's going to be very painful financially long term.
Pick up: How To Fail At Almost Everything And Still Win Big, Emotional Intelligence, The Little Book Of Behavioural Investing, Contrarian Investment Strategies: The Psychological Edge, Thinking, Fast And Slow
Ok, Now It's Time To Actually Start Value Investing
The path I've laid out for you above is a great beginner's guide to value investing but eventually you actually have to start picking stocks. That's what value investing is all about, right?
Picking stocks requires a good number of warm leads to sift through. This is what stock screeners were designed for. A stock screener will turn up a large number of warm leads but this list is just the start of your work. Some small investors make the mistake of relying totally on the output of stock screeners, and end up losing money as a result. A stock screener has major limitations that you have to be aware of.
I use Net Net Hunter's Shortlist to identify the best investment candidates. To arrive at this list, Net Net Hunter sifts through 1000 investment candidates by hand, eliminating 97% of the available firms. Many of these firms end up being junk or less-than-optimal investments so avoiding them is worthwhile. The whole process takes over 20 hours per month to complete.
Working through a bulk list compiled by a stock screener to arrive at the best candidates will require about the same amount of time - if you're doing it properly. If this sounds like a lot of work, it is. That's why most professional investors don't have day jobs.
Net Net Hunter usually dishes up around 30 firms to focus your research on. When selecting a single stock for my portfolio, I quickly sift through these companies using a select set of additional criteria such as insider buys. After 5 hours I've usually reduced the list down to 4 or 5 candidates and begin reading through 4 years of annual & quarterly financial reports, proxy statements, and press releases for each company.
I find net net stock investing to be one of the easiest investment strategies to use but, like any classic Ben Graham investment strategy, it requires strong diversification. Classic value investors should aim to hold 20 stocks to really leverage the performance attributed to their chosen strategy.
Final Thoughts On How To Start Value Investing
Many people want to earn solid returns so they can quit their job and retire well. Many more find the value investing community compelling. In my experience, few people are actually passionate about value investing itself - most see the process as a tough slog.
While being financially responsible means saving money for your future and earning good long term returns, if you're not passionate about the process of value investing, then it may not be worth venturing down this road. For me, investing is more of an obsession and one that's consumed thousands of hours of my life. Only you know deep down if you have the desire to do what it takes to invest well and, if you do, I hope that this guide has been a valuable overview of what it takes to start value investing.
If you've gotten to the end of this and are re-thinking the entire idea of investing, don't lose hope. Investors who aren't interested in spending a tremendous amount of time finding and researching high performance value stocks can still earn large market beating returns. A small step in that direction would be signing up for Broken Leg Investing's Free Newsletter.
Enter your email below to find out how to earn exceptional long term returns even if you lack the time and skill needed to put together a high performance value portfolio.