Different sources define value investing differently. Some say value investing is the investment philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios and have high dividend yields.
Others say value investing is all about buying stocks with low P/E ratios. You will even sometimes hear that value investing has more to do with the balance sheet than the income statement.
Learning From the Master
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
“We think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinate. These measures don’t definitevly represent whether an investor is indeed buying something of worth and is therefore truly operating on the principle of obtaining value in his investments.
Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – while not the usual choice for value investors, are not necessarily bad investments. Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.
Tenets of Value Investing
1. Each share of stock is an ownership interest in the underlying business
A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.
2. A stock has an intrinsic value
A stock’s intrinsic value is derived from the economic value of the underlying business. In addition to the economy value of its financial statements and assets there are also other factors. A good track record and experienced management team is also a huge consideration when making a value investment. Business plans and the ideas underlying the business, like technological advances, or its sales model must also be considered.
3. The stock market is inefficient.
Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments.
Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”Benjamin Graham – The Intelligent Investor
This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught.
4. Investing is most intelligent when it is most businesslike
Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession. An investor should treat the shares he buys and sells as a shopkeeper would treat the merchandise he deals in.
He must not make commitments where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in any investment operation unless “a reliable calculation shows that it has a fair chance to yield a reasonable profit”.
5. A true investment requires a margin of safety
A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above.
The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business (explained above). It absorbs all the damage caused by the investor’s inevitable miscalculations.
For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it ought to be a veritable chasm).
Buying dollar bills for ninety-five cents only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.
In the worst case scenario, if you buy a stock that will yield a positive return even if the company becomes liquidated is an extreme example of having a margin of safety (in the case of a price to book ratio less than 1).
What Value Investing Is Not
Value investing is purchasing a stock for less than its calculated value. Surprisingly, this fact alone separates value investing from most other investment philosophies.
True (long-term) growth investors such as Phil Fisher focus solely on the value of the business. They do not concern themselves with the price paid, because they only wish to buy shares in businesses that are truly extraordinary.
They believe that the phenomenal growth such businesses will experience over a great many years will allow them to benefit from the wonders of compounding. If the business’ value compounds fast enough, and the stock is held long enough, even a seemingly lofty price will eventually be justified.
Some so-called value investors do consider relative prices. They make decisions based on how the market is valuing other public companies in the same industry and how the market is valuing each dollar of earnings present in all businesses.
In other words, they may choose to purchase a stock simply because it appears cheap relative to its peers, or because it is trading at a lower P/E ratio than the general market. Especially when the P/E ratio may not appear particularly low in absolute or historical terms.
Should such an approach be called value investing? As a pure value investing strategy, I’d say no. However, is is a perfectly valid investment philosophy which takes into account what we usually call “value investing” but isn’t as vanilla as what Benjamin Graham or Warren Buffetts’ school of thought.
I often make investment decisions using value investing philosophy, but I also add my own personal strategies and often times relative pricing as well.
As independent thinkers we must not just blindly follow what Buffett or Graham say, but take their advice and use our own judgments. Valuing and purchasing stock of companies — even if our strategies are not 100% “Value” investing is an independent thinker’s game.
Philosophies of Thought
Value investing requires the calculation of an intrinsic value that is independent of the market price. Techniques that are supported solely (or primarily) on an empirical basis are not part of value investing. The tenets set out by Graham and expanded by others (such as Warren Buffett) form the foundation of a logical edifice.
Although there may be empirical support for techniques within value investing, Graham founded a school of thought that is highly logical. Correct reasoning is stressed over verifiable hypotheses; and causal relationships are stressed over correlative relationships.
There is a clear (and pervasive) distinction between quantitative fields of study that employ calculus and quantitative fields of study that remain purely arithmetical.
Value investing treats security analysis as a purely arithmetical field of study. Graham and Buffett were both known for having stronger natural mathematical abilities than most security analysts, and yet both men stated that the use of higher math in security analysis was a mistake. True value investing requires no more than basic math skills.
It makes sense because to analyze a balance sheet or income statement, all that is needed is basic quantitative skills. All other higher order statistics, calculus, and strange academic methods are for statisticians gambling for speculative indications of price.
Contrarian investing is sometimes thought of as a value investing sect. In practice, those who call themselves value investors and those who call themselves contrarian investors tend to buy very similar stocks.
Let’s consider the case of David Dreman, author of “The Contrarian Investor”. Dreman is known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest in behavioral finance.
However, in most cases, the line separating the value investor from the contrarian investor is fuzzy at best. Dreman’s contrarian investing strategies are derived from three measures: price to earnings, price to cash flow, and price to book value.
These same measures are closely associated with value investing and especially so-called Graham and Dodd investing (a form of value investing named for Benjamin Graham and David Dodd, the co-authors of “Security Analysis”).
So while a “Contrarian” can be a Value investor, not all contrarians are. Contrarian investors are just investors who use investment theses which are not commonly held by the general market.
Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the value of the stock is independent of the stock market.
Where the intrinsic value is calculated using an analysis of discounted future cash flows or of asset values, the resulting intrinsic value estimate is independent of the stock market (for example management team, or sound business plans or technological ideas).
A strategy that is based purely on buying stocks based on indicators like low price-to-earnings, price-to-book, and price-to-cash flow multiples relative to other stocks is not value investing. Of course, these very strategies have proven quite effective in the past, and will likely continue to work well in the future.
The magic formula devised by Joel Greenblatt is an example of one such effective technique that will often result in portfolios that resemble those constructed by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the stocks purchased.
So, while the magic formula may be effective, it isn’t true value investing. Joel Greenblatt is himself a value investor, because he does calculate the intrinsic value of the stocks he buys. Greenblatt wrote “The Little Book That Beats The Market” for an audience of investors that lacked either the ability or the inclination to value businesses.
You can not be a successful value investor unless you are willing to calculate business values. To be a value investor, you don’t have to value the business precisely – but, you do have to value the business.
While I’ve recommended books by Benjamin Graham in previous posts such as the Intelligent Investor, these works can often be very philosophical and requires a financial educational foundation to really understand.
For most people, learning about value investing is a highly intellectual task which requires a lot of financial education. The Little Book That Beats The Market by Joel Greenblatt is my favorite book that provides more definitive and practical instructions that teaches you to make value investing decisions.
Secure your future wealth, abundance, and success today by learning to invest in APPRECIATING assets.
Be DISCIPLINED and stop spending money on frivolous items, unnecessary junk, or online impulse buys. INSTEAD learn to INVEST and make your money work for YOU instead of you working for IT.
Comment below on your thoughts. As an independent thinker, I’d like to hear of what you have to say.