In some ways the expression value investing may be regarded as a rather meaningless label because it would be an irrational act to invest in something that has no value. The investor decides to make an investment on the basis of receiving something that is valuable and is not likely to lose any of its value in the foreseeable future. The expression value investing has come to imply that the investor is committing money for the long term and is making the investment on the basis of an analysis of the fundamentals of a stock which appears to be sound but undervalued.
A type of investment that cannot be described as value investing might for example be the behavior engaged in by the speculator. A speculator may be prepared to invest in something that does not necessarily have much value but which that speculator believes will quickly rise in price in the near future. In this case the belief that the price will rise is not based on an analysis of the fundamentals but may be related to the speculator’s view of the direction of general market sentiment. This type of investment is based on a view of the psychology of the market. The speculator takes the view that other investors will also buy the same stock because they see that others are doing so and this will drive the price up. The upward movement in price is therefore due to market sentiment and has nothing to do with the intrinsic value of the stock. Market emotion and market psychology are an interesting study but do not always bear much relation to the real situation as reflected in the fundamentals.
The definition of what may be called the intrinsic value of a stock or a whole business was first put forward by John Burr Williams in a work entitled The Theory of Investment Value. He defined the value of a stock or bond as the total of cash inflows and outflows that would occur during the rest of the asset’s life, discounted at an appropriate rate. This remains the definition of the intrinsic value of the asset despite the difficulty – and one could perhaps say the impossibility – of accurately estimating those future cash inflows and outflows, at any rate in the case of equity shares. The value investor wants to purchase a share in that intrinsic value at a reasonable price.
The value investor is therefore looking for an investment whose intrinsic value is greater than the current stock price. Owing to the uncertainty in arriving at an accurate computation of the intrinsic value one could follow Warren Buffett in insisting on an adequate margin of safety in the difference between the two values. This ensures that any errors in computing intrinsic value are unlikely to be great enough to take away the potential value from the investment.
If the investment is a value investment according to the above definition and is the most attractive investment available the investor should make the investment regardless of whether the asset in question is an equity share, a bond or a whole business. The question of whether the business is growing fast or is priced well above book value is not relevant if the computation of intrinsic value shows that this is well above the current price at which the investor can buy. The future growth would be taken into account in computing the intrinsic value.
For this reason there is no inevitable contradiction between making a value investment and making a growth investment. An investment in a growth company can still be a value investment according to the definition we are using. The only problem arises if the investor decides to invest in the growth company purely on the basis of its estimated growth in profits without performing the thorough analysis that would normally be done by a value investor to ensure that the price is favorable in comparison to intrinsic value.
Owing to the difficulty of projecting future cash flows, it is useful to borrow another principle from Warren Buffett and that is to always make an assessment of the quality of the management. This should in his view be done whether the whole business is being acquired or just a minority shareholding. If the management is competent and is careful to maintain shareholder value this can reassure the investor that the company can fulfill its potential in the future and continue to maintain and increase the value for the shareholders. If the investor has confidence in the quality of the management this goes some way towards counteracting any uncertainty about the accuracy of the calculation of intrinsic value.
The investor should not blindly follow the financial ratios and pursue an investment merely because these metrics appear to indicate a value investment. They are just a first indication that the value of the shares may be below intrinsic value. Further analysis, both numerical and non-numerical, is required before reaching an investment decision. Value investing involves both calculation and the use of judgment.
