WHAT IS VALUE INVESTING?

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WHAT IS VALUE INVESTING?
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What is value investing?

It’s a simple question and it has a very simple answer. But before I get to what value investing is, let me first clear up some confusion and explain what value investing isn’t.

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WHAT VALUE INVESTING IS NOT

Speculation

Speculation is the act of purchasing an asset without regard to its actual intrinsic value, with the hope that its price will go up and that you’ll be able to sell it in the future for more than you originally paid.

Speculation is the absolute antithesis of value investing.

In fact, speculation is the very thing that drove Ben Graham to galvanize the concepts that would eventually become know as value investing: Graham started teaching at Columbia Business School in 1928, a year before the Wall Street Crash of 1929 that ushered in the 10-year Great Depression that we all know about it. The Great Crash, as it’s known, was caused to a large extent by speculators, who assumed that the stock market would continue to rise at a steady breakneck pace forever. Ben Graham and his colleague David Dodd published Security Analysis in 1934 – the first financial textbook to actually teach how to calculate the intrinsic value of a business, regardless of its price.

Graham also wrote extensively about the dangers and stupidity of speculation in The Intelligent Investor.

Technical analysis

Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

A core teaching of value investing is that an asset’s price and its intrinsic value are two completely distinct things. Value investors employ fundamental analysis, which is the opposite of technical analysis. Fundamental analysis is a method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors.

Investing in low P/E , low P/B, or high dividend yield stocks

Morningstar Syle BoxThis is one of the biggest myths when it comes to value investing, and it continues to be perpetuated because it’s an easy, simple, and lazy way to classify value investors.

Take, for example, the style box that Morningstar has popularized. The style box helps characterize mutual funds by their focus on large-cap, medium-cap, and small-cap stocks, and by their “value” or “growth” orientation. A value stock, according to Morningstar, has a low price/earnings ratio, low price/book ratio, low price/cash flow ratio, and a high dividend yield. A growth stock, on the other hand, has high long-term projected earnings growth, high historical earnings growth, and high sales, cash flow, and book value growth.

Or, take this explanation of value investing and growth investing by Fidelity:

  • Value Investing: Focus on companies with lower-than-average sales and earnings growth rates. Holdings generally feature stocks with lower price-to-earnings and price-to-book ratios. Stocks generally have higher dividend yields. Fund can potentially capitalize on turnaround situations.
  • Growth Investing: Focus on companies with above average rates of growth in earnings and sales. These stocks tend to have above-market price-to-earnings and price-to-sales ratios, as the rapidly growing sales and earnings justifies a higher-than-average valuation.

While many value investors often do seek out stocks that fit the above criteria, the qualities of low valuation, low growth, and high dividend yields are not required for value investing.

The problem with these classifications and definitions is that they imply that a value investor cannot invest in a stock that has a high P/E ratio or in a business that has experienced higher than average sales growth. For example, a stock’s intrinsic value could warrant a high P/E, or the company may have low or negative earnings yet positive free cash flow – which would result in a negative P/E ratio. And dividend yields should have little to do with intrinsic value, as that cash could be better used by being plowed back into the company.

As I wrote in my very first post, What’s Better: Value Investing or Growth Investing?, there should be no difference between value investing and growth investing. The difference is between fundamental analysis / intelligent investing and technical analysis / speculation.

In this sense, value investing is synonymous with intelligent investing.

Investing in low growth, mature, or unpopular companies

This is the biggest misconception I see when it comes to value investing. and it’s very much related to the above point on value versus growth investing and low P/E, high dividend yield stocks.

The common thinking goes:

  • If growth investors look for stocks that are experiencing high growth, then value investors must look for stocks with low growth.
  • If value investors look for stocks with low P/E valuations, then these companies must be unpopular.
  • If value investors look for companies that are paying high dividends, then these companies must be in a “mature” stage of life.

I’ve already shown why the common thinking about growth, P/E ratios, and dividends are wrong. Consequently, the conclusions about low growth, popularity, and maturity are wrong as well.

Here’s an example: I invested heavily in Microsoft stock and Google stock at various points in 2010-2012. Microsoft’s dividend yield was a meager 2% and Google doesn’t even pay a dividend. And while Microsoft wasn’t necessarily considered a “hot” company around that time, Google certainly was.

So why would I, a value investor, invest in Microsoft and Google? Because their stock prices were well below my calculations of their intrinsic value. As it turns out (and without much surprise) these two stocks are among the best performers in my portfolio.

Value investors can absolutely invest in growing companies while adhering to Graham’s original principles.

SO WHAT IS VALUE INVESTING?

In Value Investing: From Graham to Buffett and Beyond, Bruce Greenwald points out that value investing in the manner initially defined by Benjamin Graham and David Dodd rests on three key characteristics of financial markets:

  1. The prices of financial securities are subject to significant and capricious movements. Mr. Market, Graham’s famous personification of the impersonal forces that determine the price of securities at any moment, show up every day to buy or sell any financial asset. He is a strange fellow, subject to all sorts of unpredictable mood swings that affect the price at which he is willing to do business.
  2. Despite these gyrations in the market prices of financial assets, many of them do have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. In other words, the intrinsic value of the security is one thing; the current price at which it is trading is something else. Though value and price may, on any given day, be identical, they often diverge.
  3. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run. Graham referred to this gap between value and price as “the margin of safety”… he wanted to buy a dollar for 50 cents.

These 3 points are core to Graham’s teachings, and are core to the definition of value investing.

But I think value investing can be defined even more succinctly than that. In summary:

Value investing is nothing more than knowing the difference between price and intrinsic value and paying less than the value you receive in return.

This is so important, it bears repeating. Value investing is nothing more than knowing the difference between price and intrinsic value and paying less than the value you receive in return.

Everything else is simply a corollary of that one key fact.

  • To know the intrinsic value of a stock, you must perform bottoms-up fundamental analysis.
  • By paying less than the value you receive in return, you automatically have a margin of safety. Sometimes the margin of safety is large (if there is great risk or a great opportunity). Sometimes the margin of safety is relatively small.
  • By knowing the difference between price and intrinsic value, then you must know about the unpredictable mood swings of Mr. Market and you should be able to control your own emotions.
  • As long as he or she is paying less than the value received in return, a value investor is free to invest in any stock (or financial asset) imaginable, regardless of whether it is a low P/E stock, high P/E stock, mature business, growing business, unpopular company, etc.

SUMMARY

Of course, there are many similarities among value investors that lead to common themes that often reappear in the subject of value investing (how to calculate intrinsic value, finding a margin of safety, contrarianism, behavioral finance). But in the simplest, rawest form, very value investor knows the difference between price and intrinsic value and seeks to pay less than the value they receive in return.

When looked at it this way, can good investing really be anything other than value investing?

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…

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