In this article series, I have introduced the concept of a value opportunity – where an investor is able to purchase part-ownership of a business for less than it is worth. Successfully doing this requires being able to estimate the value of a business. While no one knows the true value of a business since it depends on an unknowable future, a company's fundamentals can give a strong indication of what this may be. Value Investors will look at the asset value, earnings or growth to determine an estimate to compare to the current market price. The academic evidence and the example of many great investors show that when this is done well, it is a highly profitable strategy. However, like every strategy, there are pitfalls that may derail it. Because of the nature of Value Investing, the mistakes that investors make tend to be similar and are often rooted in the common errors we all make when analysing complex situations. Here are the biggest ones that Value Investors will want to avoid:
Insufficient Margin of Safety
Company valuation involves many assumptions about the future that may or may not be correct. Even with asset-based investing, investors are assuming assets can be realisable or have at least some of the value ascribed to them on the company's balance sheet. So, an investor can certainly be wrong about the difference between the fundamental value of a business and the market price. The skill of the value investor is being able to estimate the intrinsic value of a business or at least stack the odds in their favour. Because of the difficulty in doing this, many value investors also try to employ a margin of safety. They will only purchase a stock if the difference in perceived value is so significant that many adverse events can occur, and the undervaluation would remain.
The precise discount level to use for a margin of safety will vary between different value opportunities. It is best to assume that any assessment will be slightly optimistic on every factor, including the time it will take to turn a business around. If investors do this and still end up with a compelling investment thesis, this may represent a great value opportunity.
Undue Complexity
Investing in individual stocks attracts intelligent, committed, hard-working and experienced people. The problem is that such individuals tend to be attracted to complexity and…
