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What is Value Investing?
What is value investing?
Different sources define value investing differently. Some say value investing is an investment philosophy that favors buying stocks that are currently selling at low price-to-book ratios and have high dividend yields. Others say that value investing is about buying stocks with low P/E ratios. Sometimes you’ll even 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 at least enough value to justify the amount paid? Knowingly paying more for a stock than its calculated value – in the hope that it can soon be sold for an even higher price – should be classified as speculation (which is neither illegal, immoral nor – in our opinion – financially sound).
Whether it’s appropriate or not, the term “value investing” is thrown around a lot. It usually means buying stocks that have characteristics such as a low price-to-book ratio, a low price-to-earnings ratio, or a high dividend yield. Unfortunately, these characteristics, even when they appear in combination, are far from decisive for whether an investor is really buying something for what it is worth, and therefore truly acting on the principle of getting value from their investments. Accordingly, the opposite characteristics – a high price-to-book ratio, a high price-to-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.
Buffett’s definition of “investing” is the best definition of value investing. Value investing is buying a stock for less than its calculated value.
Principles of value investing
1) Each share is an ownership stake in the underlying business. A stock is not just a piece of paper that can be sold at a higher price one day in the future. Stocks represent more than a right to future cash distributions from a company. Economically, each share is an undivided interest in all of the company’s assets (both tangible and intangible) – and should be valued as such.
2) A stock has intrinsic value. The intrinsic value of a share is derived from the economic value of the underlying business.
3) The stock market is inefficient. Value investors disagree with the efficient market hypothesis. They believe that stocks often trade at prices that are higher or lower than their intrinsic value. Occasionally, the difference between the market price of a stock and the intrinsic value of that stock is large enough to allow for profitable investments. Benjamin Graham, the father of value investing, explained the inefficiency of the stock market with a metaphor. Value investors still refer to his Mr. Market metaphor today:
Imagine you own a small stake in some private company that costs you $1,000. One of your partners called Mr. Market is really very helpful. Every day it tells you how much it thinks your interest is worth, and offers to buy you back or sell you an additional stake on that basis. Sometimes his idea of value seems plausible and justified by business developments and prospects as you know them. On the other hand, often Mr. Market lets his enthusiasm or fears run away with him, and the value he proposes seems a little silly to you.
4) Investing is most intelligent when it is most business-like. This is a quote from the book “The Intelligent Investor” by Benjamin Graham. Warren Buffett believes this is the most important investment lesson he has ever learned. Investors should treat investments with the same seriousness and diligence as they treat their chosen profession. An investor should treat the stocks he buys and sells like a trader would treat the commodities he trades. He may not commit if his knowledge of the “goods” is insufficient. Furthermore, he must not engage in any investment operation unless “reliable calculation shows that it has a fair chance of yielding a reasonable profit”.
5) Real investment requires a safety margin. A margin of safety can be provided by a company’s working capital position, past earnings performance, land, goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is shown in the difference between the offered price and the intrinsic value of the deal. It absorbs all the damage caused by the investor’s inevitable miscalculations. Because of this, the margin of safety should be as wide as we humans are stupid (which means it should be a real chasm). Buying ninety-five cent dollar bills only works if you know what you’re doing; buying forty-five cent dollar bills is likely to prove profitable even for mere mortals 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 investment philosophies.
True (long-term) growth investors like Phil Fisher focus exclusively on company value. They don’t care about the price paid because they only want to buy shares in companies that are truly exceptional. They believe that the tremendous growth that such companies will experience over many years will allow them to take advantage of the wonders of blending. If the value of the company grows fast enough and the stock is held long enough, even a seemingly high price will eventually be justified.
Some so-called value investors look at relative prices. They make decisions based on how the market values other public companies in the same industry and how the market values each dollar of profit that is present in all companies. In other words, they may decide to buy a stock simply because it seems cheap compared to its peers, or because it is trading at a lower P/E ratio than the general market, even though the P/E ratio may not seem particularly low in absolute or in a historical sense.
Should we call such an approach value investing? I do not think so. It may be a perfectly valid investment philosophy, but it is different investment philosophy.
Value investing requires the calculation of intrinsic value, which 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 upon by others (such as Warren Buffett) form the foundation of a logical structure.
While there may be empirical support for techniques within value investing, Graham has established a school of thought that is very logical. Correct reasoning is emphasized over testable hypotheses; and causal relationships are emphasized over correlative relationships. Value investing can be quantitative; but arithmetic is quantitative.
There is a clear (and pervasive) difference between quantitative fields of study that use calculus and quantitative fields of study that remain purely arithmetic.. Value investing treats security analysis as a purely arithmetic field of study. Graham and Buffett were known to have stronger natural mathematical abilities than most security analysts, but both stated that using higher mathematics in security analysis was a mistake. Real value investing requires no more than basic math skills.
Contrarian investing is sometimes considered a sect of value investing. In practice, those called value investors and those called contrarian investors tend to buy very similar stocks.
Let’s look at the example of David Dreman, author of “The Contrarian Investor”. David Dreman is known as a contrarian investor. In his case, this is an appropriate label, as he has a keen interest in behavioral finance. However, in most cases, the line that separates a value investor from a contrarian investor is fuzzy at best. Dreman’s contrarian investment strategies are based on three criteria: price to earnings, price to cash flow, and price to book value. These same measures are closely related to value investing, and in particular to so-called Graham and Dodd investing (a form of value investing named after Benjamin Graham and David Dodd, co-authors of “Security Analysis”).
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 by analyzing discounted future cash flows or asset values, the resulting estimate of intrinsic value is independent of the stock market. But a strategy based on simply buying stocks that trade at 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 to be quite effective in the past and will likely work well in the future as well.
The Magic Formula devised by Joel Greenblatt is an example of one such effective technique that will often result in portfolios similar to those created 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 is not a true value investment. Joel Greenblatt is a value investor himself, as 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 had neither the ability nor the inclination to value companies.
You cannot be a value investor unless you are willing to calculate business values. To be a value investor, you don’t need to value the company exactly – but you do need to value the company.
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