Of all the questions that I hear when it comes to investing, a big chunk of it is related to valuation.
Valuation is the reasoning process where investors consider the price of buying or selling an investment. Different individuals with different risk profiles will focus and value things differently.
Personally, I tend to put a huge emphasis on the business moat of a company. And I guess that is most of the case for value growth or even dividend investors. A deep and wide moat means that a castle is well protected. Hence, it can focus on the economic welfare of its inhabitants living within the castle. Conversely, castles with small moats would focus more on defences to prevent enemies’ attack.
Quality or Value?
There is a converse relationship between quality and valuation. Companies with a quality business model will often have a higher valuation and vice versa. Hence at different ends of it lies two different styles of investing. They are growth investing and deep value investing.
When companies fail to perform in earnings, companies will be valued by their assets on hand. The company’s valuable assets, usually property and cash will be the key focus.
And this is also when the words “margin of safety” comes into the picture. Deep value investors ascribe a discount factor after valuing a company’s assets. The margin of safety of deep value investing is in the form of a share price discount against the company’s assets. Conversely, for companies with good business models, the safety factor lies within the business model itself!
Deciphering the True Meaning of Investing
Most of us agree that the stock market is one of the best ways to generate and compound wealth.
But unfortunately, for most of us, we all learnt proper investing the hard way. Most of us started investing by buying on rumours and tips. We even focused too much on valuation without understanding the companies’ business model. High P/E ratio was a straight no-no since it isn’t “value investing”.
That causes us to either lose money or miss out on great investing opportunities. And most of the time we are clueless. As Warren Buffett sums it up, investing is all about buying fantastic businesses at fair prices. Not the other way round. The business model or economic moat of the company outweighs the valuation by a mile!
Which is also why we have never heard the oracle of Omaha repeating the words “price to earnings” most of the time.
Why Is the Business Model So Important?
To explain in layman terms, a big house will definitely be more expensive than a small house. Because of the very fact that a big house has more spaces and rooms. The bigger the house, the more expensive it is. The better the business model, the more acceptable it is to be trading at a higher Price to Earnings ratio.
Some companies have grown so much that we rely more on them than they rely on a shareholder’s investments. These companies become a way of life. How we search for information online, how we find directions on the go, or redefining what entertainment is all about.
Contrary to other companies who are in a congested or obsolete business model. Due to high competition or being in a sunset industry, time slowly made the company more and more irrelevant in our lives. Decreased earnings and pessimism on the company’s growth will deteriorate share prices. Hence, we get a lower Price-To-Earnings ratio.
So, is Deep Value Investing A Gamble?
Growth investing and deep value investing both involves taking calculated risks. Growth investors take a bet on a high growth company’s future expansion. Deep value investors take calculated risks on the discounted asset valuation.
Both investing styles focus on different aspects of a company. Both have their own risks. High growth tech companies can sometimes find themselves behind the next technological breakthrough. Deep value investors might have stumbled onto a value trap.
Which Is Riskier?
Risk comes from knowing what you do not know. But, using the wrong approach to value companies is the riskiest mistake of all. Asking for a greedy margin of safety for a high- quality company would only occur once in a blue moon. It might not even happen (Just look at how Amazon Inc.’s share price performed during the COVID-19 pandemic).
Both growth investing and deep value investing are proven methods to profit from the stock market. But using the wrong methods to evaluate companies wrongly is the ultimate mistake. We either lose out on the share price or end up betting on the wrong horse.
None of us is oblivious when it comes to quality and valuation. We all know that a bigger house is more valuable than a smaller house. We are also aware that a smaller house in the city might even cost more than a mansion in an isolated area. The logical thought context that goes into buying a property applies to equity investing as well.
Are you buying to rent or for your own stay? Are you buying the location or the size?
Are you buying a fantastic business or a cheap business?