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To grow your wealth passively and safely for the long term, value investing is one of the best ways. Today, I am going to share with you a step-by-step blueprint to help you do just that.
Here’s a simple 5 step plan:
Step 1: Build a research list of stocks
First of all, you need to identify what industry or sector you are interested in.
Preferably, it is an industry that you have a lot of knowledge about. Because you have more insight about the industry, it helps you make better investment decisions.
For example, you could have been working in a certain industry for years. You know the ins and outs of the industry. What is important for a company in this industry to make money? What are the growth prospects for the industry? What are the challenges faced by the industry? Which company has a competitive advantage?
Once you have identified the industry that you want to invest in, you find stocks in that industry that you can add to your research list.
Here are just a few ways that you can find stocks:
- Follow Guru
You can find out what stocks the investment gurus are buying.
There is a website called GuruFocus where you can get detailed information about investment gurus’ stock portfolios, including the average price they bought their stocks at.
All you need to do is type in the guru’s name and choose their stock picks.
You can also find stocks through news.
In the news, we mostly hear about the big and well known stocks.
But for the less commonly known ones to make it into the news, it has to be either very good or very bad news.
Sometimes, the news can offer us good investment opportunities.
Remember value investors seek buying opportunities when people behave irrationally in the stock market.
What are some of the irrational behaviors?
- Overselling out of fear
- Overbuying out of greed
When good stocks are being oversold out of fear, that is the perfect opportunity that value investors are waiting for.
- Stock Screener
You can use stock screener to build a list of research stocks.
Stock screeners have built-in filters to let you filter out stocks based on your criteria. For example, you can filter stocks based on one factor such as market capitalization and P/E ratio or a combination of a few different factors.
The screener saves you a lot of time from going through thousands of stocks.
Step 2: Determine whether or not it’s a good business to invest in
Now, you have your research list of stocks.
Next, you analyze the stocks one by one to find out which ones are worth investing in.
To help you decide, you look at the following things:
- Financial numbers
Looking at the company’s financials will give us an idea about its financial performance as well as its financial position.
For example, you can find out about the profitability of the business by looking at the earnings for the past few years.
Is it positive?
Has it been growing consistently?
Also, you can find out about the liquidity of the business by examining the cash inflow and outflow.
Does it have positive cash flow consistently for the past few years?
Cash flow is the life blood of any business.
Without positive cash flow, businesses will not be able to survive for long.
- Sustainable Competitive Advantage
A sustainable competitive advantage allows the business to protect its long term profits from its competitors.
So, how do you identify the competitive advantage of the business?
Here are some common types of competitive advantages:
- Intangible Asset
- Cost Advantage
- Network Effect
- Switching Cost
- Efficient Scale
Take cost advantage for example.
Companies can gain cost advantage through economies of scale.
It allows them to sell their products at the same price as their competitors for more profits. At the same time, it gives them the option to undercut their competitors.
A good example is Walmart.
With more than 6000 stores worldwide, it keeps its cost low through scale efficiency. Also, it gives Walmart tremendous bargaining power with its suppliers.
For businesses, there is always risk.
Before you invest in any business, you have to analyze the risks involved.
Here are a few types of risks to consider:
- Regulatory Risk
- Inflation Risk
- Science & Tech Risk
If the risk is too high compared to the potential returns, it would not make sense to invest in it.
Step 3: Determine what price to buy it at
After you have decided whether or not it’s a good business to buy, you need to find out what price we want to buy at.
Is the current stock price too high?
Or is the current stock price a good price to go in?
To make that decision, you will need to value the company first.
Based on your valuation, you can arrive at your estimated intrinsic value of the company.
Target Buy Price = Intrinsic Value – Margin Of Safety
So, what is margin of safety?
” According to Investopedia, margin of safety refers to a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. “
Then, how do you determine your margin of safety?
For example, you can apply a fixed percentage discount such as 20% to the estimated intrinsic value. This 20% discount will be your margin of safety.
All in all, margin of safety allows you to buy a good company at a much cheaper price for added protection.
In other words, you are buying it when it’s being undervalued and your downside risk is further reduced.
Step 4: Build A Portfolio
Now, you have a list of stocks that you want to buy as well as your target buy price for each stock.
Next, you need to think about how much funds you are planning to allocate for investment.
This will give you an idea about your portfolio size.
For example, you might be planning to invest $5,000 a year for the next 5 years.
Then, your portfolio size would be $25,000 by the end of the 5 years.
Or you might already have a sizable savings that you want to use for investments.
Let say, you have $50,000 in savings that you want to put into stock investments.
Then, your portfolio size would be $50,000.
Besides your portfolio size, you also need to think about what your investment objectives are and how long your investment horizon is.
Investment horizon refers to the total length of time you expect to hold your portfolio.
This will guide you to build an investment portfolio to achieve your investment goals within your investment horizon.
So, how do you get started building a investment portfolio?
First, you need to understand that there are two types of investments:
- Growth stocks that are undervalued
- Dividend stocks
For dividend stocks, they could give you dividend income year after year.
On the other hand, growth stocks that are undervalued could give you big capital gain when the stock price goes up substantially.
So, ask yourself whether you want more income or more capital gain from your stock investments.
Next, how much time are you willing to put into stock investing?
Do you think you are an active investor?
Or a passive investor?
Or a semi-active investor?
Depending on your individual situation, you will have different investment allocation that suits your investment objectives.
For example, if you are a passive investor who prefers dividend income, you will have a higher percentage of dividend stocks and ETFs in your portfolios.
However, if you are an active investor who looks for capital gain, you will have a higher percentage of growth stocks in your portfolio. In your case, you can also employ value investing option strategy to help you generate passive income and boost your returns WITHOUT additional risk.
Another important aspect in building your portfolio which is your position sizing.
“Position sizing refers to the size of a position within a particular portfolio, or the dollar amount that an investor is going to invest.”
As a general guideline, you don’t want to invest more than 10% of your entire investment account in one single stock.
Step 5: Portfolio Review
Now you have finished building your stock portfolio.
But, your job is not done yet.
Because you still need to monitor and review your stock portfolio periodically.
Here are some review conditions for your portfolio:
- Stock has reached your desired returns
- Stock becomes overvalued
- Reason for buying the stock is no longer valid
- There are much better opportunities
- Portfolio needs re-balancing
In summary, when you follow this simple five-step plan, you will be able to build a balanced portfolio based on value investing strategy with the aim of helping you achieve your investment objectives.