Home > Articles > What Is Value Investing

What Is Value Investing

What Is Value Investing ?

People ask what is value investing if they are curious how one of the world’s richest man, Warren Buffett using such value investing approach to accumulate his wealth for many decades in a consistent manner.

A simple answer to what is value investing is simply the strategy of acquiring stocks at a huge discount to their intrinsic value. Such intrinsic value of stocks can be derived via fundamental analysis without referring to the market value.

This value investing approach will require the investor to adopt a contrarian mindset for a long term perspective. A stock can fall in price below its intrinsic value due to different reasons such as short term profit warning. This makes it attractive enough for value investors like us to buy and hold it until a set profit target is met. From value investors’ perspective, the impact of short term profits falls on long term value of a business is often small. Hence, value investors understand Value investing is not always in favour and does not always outperform over shorter time periods. As proven over the last 100 years, adopting value investing strategy has a consistent history of outperforming index returns across multiple equity markets.

Different articles define what is 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.

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).”

The term ‘value investing’ is widely used. Typically, it means 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 may not determine if an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. On the contrary, a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are also in no way inconsistent with a ‘value’ purchase.”

Warren Buffett’s definition of “what is value investing” is the 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.

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.”

4) Investing is most intelligent when it is most businesslike. 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. 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. 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.

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.

Long-term growth investors 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, even though the P/E ratio may not appear particularly low in absolute or historical terms. Should such an approach be called value investing? It is not. It may be a perfectly valid investment philosophy, but it is a different investment philosophy from value investing.

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. Value investing may be quantitative; but, it is arithmetically quantitative. True value investing requires no more than basic math skills.

Conclusions

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 truly 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. But, retail investors often adopt a strategy that is 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 quite effective in the past, and will likely continue to work well in the future.

You can not be a 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.

Sign up now for a free value investing singapore seminar package (worth S$349) to learn what is value investing and how this can be done in a smarter way.

 

free value investing singapore seminar

                     

value investing singapore seminar bonuses


Leave a Reply

Your email address will not be published. Required fields are marked *

*