Value investing as an investment practice was popularized by Benjamin Graham and David Dodd in their 1934 classic treatise “Security Analysis”. The idea itself rests on a very simple premise: Stock prices tend to differ from the intrinsic value of the company in the short term. In the long term however, the stock price and the intrinsic value of the company converge. Therefore, if an investor purchases a stock when it can be bought at a discount to the intrinsic value, the investment is likely to be profitable as the stock price rises to erase the discount or even trade at a premium.
What About the Market Efficiency?
Efficient Market Hypothesis states that the stock price at any given moment accurately reflects all the information that is available. One implication of this hypothesis is that the stock prices will never trade at a discount or a premium to the intrinsic value.
Value investors believe that the markets are generally inefficient in the short term. Stock prices can and do move to the extremes on both the up side as well as the down side. While Efficient Market Hypothesis is an useful approximation to how the stock market works, it does not work in all situations.
Value Investing Strategy
Value investing strategy suggests we should buy a stock when it sells at a discount to intrinsic value and sell it when it trades at a premium to the intrinsic value. As simple as the idea is, the value investing strategy can be a little difficult to put in practice. To see why, let’s consider the following:
- What is the Intrinsic Value of the Company?:
Intrinsic value is an equivalent concept to the Net Worth. When evaluating businesses, intrinsic value can be hard to arrive at. As investors are removed from the day to day operations of the company, they are necessarily reduced to making assumptions about asset uses and values. They may also make back-of-the-envelope estimates for future earnings and revenues. Even if an investor has access to greater detail of the financial position than what the company is required to disclose to the public (for example, an acquirer will go through the books in detail as part of their due diligence), any projections or future estimates will likely vary from the eventual results. As a result, investors tend to use certain key financial ratios to arrive at a valuation that is “close enough”.
A value investor also realizes that valuation and analysis is necessarily not an exact science. There are many ways errors can be introduced in the process, and some of these errors might have disproportionate effect on the intrinsic value calculation. As a result, the value investor is advised to lean towards conservatism in assumptions.
- How to Insure that the Valuation Gap will Close with the Stock Price Rising?:
After all, it is also possible that the intrinsic value of the company may fall!
The short answer is that if there is a reasonable confidence that the company will remain profitable in the near future, it is very likely that the intrinsic value of the company will not decline, and only grow. A growing intrinsic value should in the long run cause an increase in the stock price. However, keep in mind that companies may be able to show an accounting profit even as in reality the business may be running losses, at least in the short run. It is best to adjust the accruals to cash basis where possible to get a true picture of the business fundamentals. Cash flow analysis becomes critical.
Most classical value investors eschew any reliance on future revenues or profits as these are inherently unreliable. Rather, they insist on enough intrinsic value to exist in the net assets of the company. Using a balance sheet is a more conservative way to calculate intrinsic value than running a discount cash flow calculation using estimates for future cash flow or earnings. This narrows down the investment options considerably. A value investor needs to cultivate discipline and only invest when the conviction is high and risk of capital loss is low.