Beginners Guide To Value Investing
Exploring the value investment philosophy of buying undervalued stock which is sold below intrinsic value.
In this post, we’ll take a look at:
🧠Key Takeaways
Value investors buy stocks when a sufficient discount to fundamental value exists. This discount is called the margin of safety and it helps to reduce risk for the investor. Once the share price reflects fair value they will sell the stock. Value investing works because markets are mean-reverting and market participants act irrational.
Approaches to investing vary widely between different investors. Some invest only in specific markets or technologies while others select companies based on optimistic predictions or gut feeling. The value investing strategy looks at investing differently by asking what value investors get for the price they pay.
What Is Value Investing?
Value investing is a time-tested and proven stock investing strategy which is being used by some of the most successful investors. A value investor buys stocks when the company is traded below its fundamental value and sells them once the price reflects fundamental value. Therefore their primary goal is to achieve profits by buying stocks at a discount as this allows them to maximize their returns.
“Whereas some investors are company- or concept-driven, anxious to invest in a particular industry, technology, or fad without special concern for price, a value investor is purposefully driven by price.”
Value investors tend to be risk-averse investors with a low risk tolerance who only invest when they fully understand the company they invest in. The presence of a sufficient discount is also a key condition for value investors to make an investment.
These discounts are often well-hidden which is why these stocks are often undervalued in the first place. As a result it can often take months or years before undervalued stocks are being traded at their fair market value and value investors can cash out. Therefore one of the most important characteristics a value investor must have is patience.
Locating investments which are trading below their fundamental value is hard and time-consuming. It involves a long research process in which most potential candidates will be discarded. Value stocks are also easier to find in a bear market rather than bull market as they tend to trade at lower share prices.
What Is The History Of Value Investing?
The original idea of value investing was developed by Benjamin Graham, who is considered the father of value investing, and David Dodd in the 1920s. They believed that the value of a company’s stock could be determined through a fundamental analysis of the company. This stood in stark contract with the existing idea of predicting movements of stock prices. Graham and Dodd later published their idea of value investing in the book “Security Analysis”. Later the book “The Intelligent Investor” by Graham followed.
“The best lessons are the ones I learned at Columbia. I went there because Ben Graham taught there and I think his advice was timeless…. The lessons are simple, but powerful….What I learned at 19 or 20 from him, I applied ever since.”
Benjamin Graham later taught his approach to value investing at the Columbia Business School in New York City. One of his students was Warren Buffett who is one of the best known value investor. He applied the teachings of Graham and developed them further into the idea of owning “wonderful companies at great prices”. It means that if a company is able to provide continuous value to its investors it can be profitable for the investor even if the available discount is smaller than other value stocks.
Since then value investing has been practiced by some of the most successful investors such as Warren Buffett, Seth Klarman, Howard Marks, Michael Burry, Tobias Carlisle, Joel Greenblatt and many others.
Why Does Value Investing Work?
Efficient Market Hypothesis
The efficient market hypothesis states that all stock market participants act rational and efficiently as they have access to the same information. Therefore stocks should always trade at their fair value and should not sell below or above their fair price.
However in the view of value investors the efficient market hypothesis does not work in reality. There are many stock price influences which can cause irrational behavior by market participants. As a result they often act irrationally and against their best interest.
“When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not a risky at all.”
A single tweet of the CEO of a public company might cause a company’s stock price to drop while positive news might cause more excitement then warranted. Also a stock might simply be undervalued because the current stock market environment encourages greedy or fearful behavior or because a certain industry is considered risky or out-of-favor. In addition a stock might also simply fly under the radar and not receive a lot of news coverage causing less interest by investors. For value investors these cases create many attractive opportunities to buy undervalued stocks with limited risk.
Mean Reversion
Most market participants tend to be too over-optimistic and think that positive trends will continue forever. However in reality these trends never continue forever and instead will sooner or later revert back to the mean. This process is called mean reversion.
Mean reversion pushes up share prices of undervalued companies and pushes down prices of overvalued companies. The process not only applies to share prices but also to business, industries and whole economies. It is the expected outcome but to most investors it is unexpected.
“The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.”
The reason why share prices and businesses revert back to the mean is that fast growth and high profits attract competition. This competition makes those successful companies less profitable causing the profits of existing companies to fall. This leads to the reversion of the trend. As a result companies will start to leave the market or to go bankrupt which in turn leads to faster growth opportunities and bigger profits.
Margin Of Safety
Most textbooks define the risk of investing as share price volatility. This means that stocks with volatile stock prices are seen by many as riskier investments. However most value investors would disagree with this notion and instead see the partial or total loss of capital as the real risk in investing.
Therefore the primary objective of many investors is achieve a maximum investment return with as little risk as possible. To achieve this they use a principle called “margin of safety”. The margin of safety is the difference between the current undervalued share price and the predicted share price a company would have when it is being traded for intrinsic value.
A company is unlikely to trade below intrinsic value for a longer time as it is neither in the interest of the management nor of existing shareholders. For the management of a company trading at a discount to fundamental value means that it becomes a takeover target for competitors. Existing shareholder on the other hand would receive less profits than they should when selling their stakes while the company is undervalued. As a result the company’s share price usually adjust to fundamental value again if the company is undervalued.
This is why the margin of safety is so effective for value investors. It provides a built-in guarantee that the company’s share price will appreciate towards fundamental value and therefore profits can be made. At the same time it also protects value investors from worst case scenarios as the share price is already depressed compared to the true intrinsic value of the company when they invest.
What Are Characteristics Of Value Stocks?
As value investors aim to buy stocks at a discount they often have to look in out-of-favor industries or consider obscure investments, like small-cap stocks, spin-offs, distressed companies, liquidations or stocks with low analyst coverage. Most investors will avoids these companies leading to low prices. However value investors expect these low prices to eventually rise due to some catalyst they identified.
“Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short-term, which sometimes can be as long as two or three years, there are periods when it doesn’t work.”
While value investors agree about the principle of buying companies at a discount there are as many strategies as there are investors. In general all value stocks have in common that their stock price is below the intrinsic value of the company. The intrinsic value is the true value of a company based on the known facts, such as the value of the company’s assets and its liabilities.
However the definition of intrinsic value differs between investors. Some value investors select value investments based on a low P/E ratio while others, like Michael Burry, use the Enterprise Value-to-EBITDA ratio. Other commonly used values are also the price-to-book value ratio or the dividend yield. In the end it depends on the value investing strategies of the individual investors.
There are also other factors which play a role. Christopher H. Browne suggests to look at the potential to improve earnings and reduce spending. He also puts a big emphasis on the confidence of the management and other insiders. Other investors like Warren Buffett only invest into industries they understand. He also considers intangible assets like brand names or patents. Both Browne and Buffett also like to see share buybacks to take place. Value stocks should also have no or little debt.
What Are Value Traps?
When screening stocks some potential value stocks might look undervalued on paper due to trading at low valuation metrics. For example they might have a low P/E ratio or P/B ratio. However they can often turn out to be value traps. A value trap is a stock which looks cheap but in reality is not cheap at all.
While these value traps might seems like a bargain their share price tends to either stay within the same price range or even drop further. The reason is often the absence of growth opportunities, management, efficiency or cost improvements.
Therefore value investors should always figure out a catalyst that will turn undervalued companies into fairly valued ones. The presence of a discount to fair value alone is usually not enough to identify good value stock opportunities.
How Does Value Investing Compare To Growth Investing?
Value investors tends to be more focused on the present value they receive when investing into value stocks. Growth investors on the other hand rather look at the future growth prospects of growth stocks. These growth companies usually exist in fast-growing markets or industries and tend to be less established than traditional value stocks. Many of them are also younger companies and are often unprofitable and might have higher debt.
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