What is value investing?

What is value investing?

Different sources define value investing differently. Some say that value investing is the investment philosophy that favors buying stocks that currently sell for a low price-to-book ratio and have high dividend yields. Others say that value investing is about buying stocks with low P/E ratios. You’ll even sometimes hear that value investing has more to do with the balance sheet than the income statement.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:

We believe that the very term “value investing” is redundant. What is “investing” if not the act of seeking value at least sufficient to justify the amount paid? Knowingly paying more for a stock than its calculated value, in the hope that it may soon sell for an even higher price, should be labeled as speculation (which is not illegal, immoral, or, in our opinion, financially fattening).

Whether appropriate or not, the term “value investing” is widely used. It generally connotes the purchase of stocks that have attributes such as a low price-to-book ratio, low price-earnings ratio, or high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is buying something for what it’s worth, and is therefore truly operating on the principle of getting value out of it. Consequently, the opposite characteristics (a high price-to-book ratio, a high price-earnings ratio, and a low dividend yield) are by no means incompatible with a “value” purchase.

Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is buying a stock for less than its calculated value.

Principles of value investing

1) Each share is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold for a higher price at a future date. The shares represent more than the right to receive future cash distributions from the company. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible), and should be valued as such.

2) A stock has intrinsic value. The intrinsic value of a stock is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe that stocks often trade at prices above or below their intrinsic values. Occasionally, the difference between a stock’s market price and that stock’s intrinsic value is wide enough to allow for profitable investments. Benjamin Graham, the father of value investing, explained the inefficiency of the stock market using a metaphor. Value investors still refer to his Mr. Market metaphor:

Imagine that in some private business you have a small share that costs you $1,000. One of his partners named Mr. Market is really very helpful. He every day he tells you how much he thinks the interest on him is worth and offers you more to either buy it or sell you additional interest on that basis. Sometimes his idea of ​​value seems plausible and justified by business developments and prospects as he knows them. Often, on the other hand, Mr. Mercado lets his enthusiasm or his fear get the best of him, and the value he proposes seems a bit silly to him.

4) Investing is smarter when it’s more entrepreneurial. This is a quote from “The Intelligent Investor” by Benjamin Graham. Warren Buffett thinks it’s the most important investment lesson he’s ever been taught. Investors must treat investment with the seriousness and diligence with which they treat their chosen profession. An investor must treat the stocks he buys and sells as a trader would treat the commodities he trades. He must not compromise when his knowledge of the “commodity” is inadequate. In addition, he must not participate in any investment transaction unless “a reliable calculation shows that he has a good chance of generating a reasonable profit.”

5) A true investment requires a margin of safety. A margin of safety can be provided by a company’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 listing price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the safety margin must be as wide as stupid we humans are (that is, it must be a true abyss). 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 pay off even for mortal mothers like us.

What value investing is not

Value investing is buying a stock for less than its calculated value. Surprisingly, this fact alone separates value investing from most other investing philosophies.

True growth (long-term) investors like Phil Fisher focus solely on the value of the business.. They don’t care about the price paid, because they only want to buy shares in businesses that are truly extraordinary. They believe that the phenomenal growth such companies will experience over many years will allow them to benefit from the wonders of capitalization. If the value of the business rises fast enough and the shares are held long enough, even a seemingly high price will eventually justify itself.

Some so-called value investors consider relative prices. They make decisions based on how the market values ​​other public companies in the same industry and how the market values ​​every dollar of profit present in all businesses. In other words, they may choose to buy a stock simply because it looks cheap compared to its peers, or because it is trading at a lower P/E than the broader market, even though the P/E doesn’t look particularly low. in absolute or historical terms.

Should this approach be called value investing? I do not think. It may be a perfectly valid investment philosophy, but it is a different investment philosophy.

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 principles established by Graham and expanded by others (such as Warren Buffett) form the basis of a logical edifice.

Although there may be empirical support for the techniques within value investing, Graham founded a school of thought that is very logical. Correct reasoning on verifiable assumptions is emphasized; and causal relationships are emphasized over correlative relationships. Value investing can be quantitative; but, it is arithmetically quantitative.

There is a clear (and widespread) distinction between quantitative fields of study that employ calculus and quantitative fields of study that remain purely arithmetic.. Value investing treats value analysis as a purely arithmetical field of study. Graham and Buffett were known to have stronger natural math skills than most security analysts, and yet both claimed that the use of higher math in security analysis was a mistake. Real value investing requires no more than basic math skills.

Contrarian investing is sometimes considered 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.

Consider the case of David Dreman, author of “The Contrarian Investor.” David Dreman is known as a contrarian investor. In his case, it’s an appropriate label, given his keen interest in behavioral finance. However, in most cases, the line between value investor and contrarian investor is blurred at best. Dreman’s contrarian investment 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 after Benjamin Graham and David Dodd, the co-authors of “Security Analysis”).

recommendations

Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the stock’s value is truly independent of the stock market.. When intrinsic value is calculated using discounted future cash flow or asset value analysis, the resulting intrinsic value estimate is independent of the stock market. However, a strategy that is simply based on buying stocks that are trading at low price-earnings, price-book, and price-cashflow multiples relative to other stocks is not a value investment. Of course, these same 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 built by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the shares purchased. So while the magic formula may be effective, it’s not a true value investment. Joel Greenblatt is a value investor, because he calculates the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book That Beats The Market for an audience of investors who lacked the ability or inclination to value businesses.

You cannot be a value investor unless you are willing to calculate trading values. To be a value investor, you don’t have to value the business accurately, but you do have to value the business.