What is Value Investing?
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.
See also: warrants vs options
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.
What is a 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. Read more about estimating the intrinsic value of a company
- 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.
Read: how to analyze a stock
Most classical value investors eschew any reliance on future revenues or profits of a company 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.
Is Value Investing a Good Strategy?
Value investing as a strategy has a great pedigree and long history of success. It has been shown that over time any bias towards value (such as value stocks with low price/book ratio or low price/earnings ratio or low price/sales ratio) generates a better return than the total stock market. Serious investors can do even better by practicing classic value investing, and by exploiting other value factors such as high earnings yield or low PEG. It does however require more than just picking the right value stocks. Investors need to be able to judge their actions properly, and they need to structure their investment portfolio to allow for maximum portfolio growth. Additionally the investment horizon needs to be long. Do not expect to stop investing at retirement – most value stocks need time to mature their profit potential.
What do Value Investors do When Markets are not Favorable?
Since most markets are cyclical with booms punctuated by busts or recessions, there are times when value investing does not work for a number of years at a stretch. For example, the US stock market starting from 2008 has seen tremendous growth, but most of the growth has come from momentum stocks. Value stocks have taken a back seat and have underperformed as a group. Investors looking for undervalued stocks have not found many candidates to actual make up a reasonable portfolio. These markets can be frustrating, however a dyed in the wool value investor will find several ways to cope.
- Going deep: Paucity of good value stocks means there are less investment ideas. However, there may be some ideas in hidden corners of the market. For example, ADRs that trade OTC. Or perhaps a stock that is being removed from an index and is therefore being sold off.
- Special situations: Mergers, acquisitions, spinoffs and carve outs create special situations that can temporarily distort the valuations
- Distressed debt: not for the faint-hearted, but investing in distressed debt or liquidating companies can be very profitable if you know what you are doing. It can also be dangerous as the liquidity is very low and there are multiple counterparties to negotiate with
- Index funds: If all else is not an option, investors can ride out the market exuberance by putting their capital into index funds and then re-engaging when the conditions are more favorable for value investing.
Is Warren Buffett a Value Investor?
Warren Buffett started out as a classic value investor in the Ben Graham mold (see the next section). Over time as his capital grew, he had to migrate his investment dollars to larger cap companies. As a result, classic value plays became hard to find. Buffett now a days invests in Quality companies at reasonable prices – not necessarily in stocks selling for pennies on the dollar. In that sense, Warren Buffett is no longer a value investor.
What is the Difference between Graham School of Value Investing and Buffett School of Value Investing?
Although never explicitly stated, the Graham school of value investing is what is considered the Classical Value Investing. Graham placed great emphasis on current and historical fundamentals as see on balance sheet and cash flow statements. For a stock to be considered a great value, it needs to show the undervaluation based on what exists now, not on some nebulous future estimate of growth.
Buffett, on the advice of Charlie Munger, has strayed considerably from this principle. He is on the record stating he likes to buy great companies at fair price, and the great companies are determined by whether there exists a moat to protect and grow market share and margins in the future. He is willing to pay up for quality companies. Graham does not pay up.
Additionally, for Graham all information that mattered existed on the audited financial statements. Management skills were not important. Buffett places a great deal of importance on the quality of management as he likes to take ownership of entire businesses at times.
Is Value Investing Dead?
Every few years investors ask the question: Is value investing dead? Investors see that value stocks are no longer performing well and the markets are rocketing higher with growth stocks. The glamour and glitz of high growth stocks can be very tempting to many investors, but this is the proverbial flash in the pan. For every Amazon and Google, there are countless high growing companies that fizzled out and investors lost their investments. The fact is, stocks do well when the companies do well, and companies that do well generally have or quickly build a sustainable competitive advantage over others in the industry. Quality, it would seem, is the key determinant of which stocks succeed. Value, as we can anticipate, arises from quality, as the quality and the sustainable competitive advantage provides a moat.
No, value investing is not dead. There are investing cycles, there are times when value is ascendant, and then there are times when growth reigns supreme. The times when growth looks to be winning are the times when there are sectors and stocks that seem to be languishing creating compelling values that will power the next value up-cycle. Any time investors start asking if value investing is dead, is likely to be a great time to start positioning your value portfolio for the next leg up.
What is Your Favorite Value Stock Investing Book?
There are many value investing books I like and I think investors should read. Every book has its own approach and takes us into the mind of the practitioner. I have noted the books I like and can recommend here.
- Fact, Fiction, and Value Investing – CLIFFORD ASNESS, ANDREA FRAZZINI, RONEN ISRAEL AND TOBIAS MOSKOWITZ, Journal of Portfolio Management (Draft)
- Value Investing for Grown Ups – Aswath Damodaran, Stern School of Business
- Value Investing Articles
- Qualities You Need to Succeed at Value Investing