Value Investing, a term most commonly used in investing philosophy was coined Graham in the 20th century by Benjamin Graham and therefore he is called the Father of Value Investing.
He believed that it is very difficult for a common investor to beat the markets on a consistent basis and therefore came up with this concept which could help investors make a judgment by using the approach of value investing. He authored the book “The Intelligent Investor” which is still regarded as a masterpiece in teaching people this concept.
So interesting and analytical was his concept on value investing that later, Warren Buffet, one of the most notable investors in the world today had become his student in Columbia Business School where Mr. Graham advocated this idea.
In this article
What is Value Investing?
Value Investing is in total contrast to growth investing.
In the former, we seek to maximize our returns by identifying stocks that are currently undervalued in the markets. The process of value investing starts with finding the true value of a company also known as intrinsic value often through various methods of valuation such as discounted cash flow analysis or dividend discount model.
Another term that is used in tandem with intrinsic value in value investing is the concept called margin of safety.
Let us understand this with the help of an example.
Mr. A wants comes up with the valuation of XYZ Company at INR 1000. The current price quoted in the market for this company is INR 750 and Mr. A wants a margin of safety of 20% (i.e. he would be willing to buy the stock only if it is less than INR 800 as 20% margin for INR 1000 is INR 200).
The key advantage of using margin of safety is that it minimizes the chances of permanent loss of capital for the investor. Unlike in the case of speculative stocks, where the prices may fall drastically, it is less probable that value stocks will experience the same decline.
Therefore, investors in value investing look at both these terms (Intrinsic Value and Margin of Safety) before taking a final call.
If Intrinsic Value > Market Value; then buy the stock
If Intrinsic Value < Market Value; then sell the stock
What Do You Look For in Companies While Carrying out Value Investing?
Mr. Benjamin Graham had seen the market crash which occured during the Great Depression when Dow Jones Industrial Average had corrected significantly.
He understood that it was very difficult for naïve investors to come and start making profits form the market. So, he came up with a concept to identify companies trading at a discounted price.
He believed that investors should pay attention to the price-to-book ratio (P/BV), focusing on stocks with a clear tangible value on their balance sheets and avoiding stocks with a price-to-book ratio of more than 1.33.
In other words, he believed that a stock’s price should reflect its book value (i.e. the value of its assets minus liabilities), and thought that the market price for the company in question should not exceed the 1.33 of the book value.
This concept of value investing has been further carried on by Mr. Warren Buffet; whereby he quotes the term “economic moats” in a business.
These moats can be anything such as strategic advantage, brand image, geographic spread, reasonable costs etc. that differentiates the company from other peers in the markets.
He always looks for companies that are fairly priced (having a low P/E and P/BV ratio) at the same time companies having high dividend yields.
He closely follows the saying quoted by him “It is much better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Apart from the methods mentioned above, there are also other parameters we can use to employ value investing as shown below.
The process of value investing entails the following steps:
1.Checking valuation metrics such as P/E, P/BV, EV/EBITDA etc.
2.Generation of ideas through stock screening
3.In depth financial analysis
4.Checking for business growth prospects
5. Portfolio construction and monitoring
Principles of Value Investing
Apart from looking at core metrics of intrinsic value and margin of safety, there are two more principles that one needs to follow in case of value investing. Let us now discuss these.
1. Not Conforming to the Concept of Efficient Market Hypothesis
A value investor does not acknowledge the concept of Efficient Market Hypothesis (EMH) meaning that the current market price takes into account all the information that has been shared about the company.
Therefore, value investors are quite contrary to this belief and expect the stock prices to be undervalued or overvalued at times.
2. The Perspective of a Business Owner
Value investors also approach the stock valuation from the eyes of a business owner as the management has a major role to play in the performance of the company.
Reflecting on the words of Mr. Warren Buffet, “look for three qualities: integrity, intelligence and energy. And if they don’t have the first, the other two will kill you”.
Does Value Investing Really Add Value?
This is probably the next big question.
Human beings generally use the price of something to judge its intrinsic value. Though it is not always wrong to do so, when we follow the same principle of equating the intrinsic value of a stock to its current price, we might go wrong entirely. Meaning if this is an element of human nature, then what will be its effect on investing?
If the stock price of a particular company rises, more people would believe instinctively that there is something good about the company which is actually driving its growth.
However, at its very heart, value investing is the style of investing that does the exactly the opposite to this principle. The principle of value investing works because there is a presence of a few irrational investors in the market who do not realize the true potential of a stock and therefore sell it.
It is only a true value investor who can estimate the stock’s ability to generate returns in the future, meaning that the stock is currently underpriced.
Though situations may pan out in such a way that there might be factors that potentially lead our stocks to an opposite direction.
For example, few macro factors turn against our investments, industry or sector policies change against the growth of the company invested in, global factors that might impact the sector at large etc
However, these factors may play out in the future, so the only control that we as investors have is, on the price of the stock.
Therefore, the real essence of value investing whereby we select stocks that is based on the price is under our control and so value investing does really add value to our investments.
Wrapping it Up
Now that you have a fair idea about value investing, you must note that value investing is fundamentally different from trading in stocks.
While the latter focuses more on price movement and other technical indicators, the former focuses on analyzing the business behind the stock and buying the stocks at a relatively cheaper price and anticipating it to reach the price as was thought by the investor.
Value investing also generally has a longer time span than other kinds of investing. This is because it generally employs a buy and hold strategy until the value of the investment actually plays out.
Disclaimer: The views expressed in this post are that of the author and not those of Groww