The Definition of Value Investing
Investing in profitable companies that represent excellent value to the buyer. Essentially buying a share of a profitable company when its shares trade at a significant discount to its actual intrinsic value.
What is Value Investing?
“Value investing is a school of investing based on the assumption that the stock market participants do not value a company correctly. Value investors believe they can make a healthy long-term profit by identifying profitable companies that the stock market undervalues.”
Value investing is both a philosophy and a strategy of investment. The philosophy is that an asset’s value is its most important characteristic.
The strategy is that the market cannot properly value stocks, but well-informed investors can. Value gurus like Warren Buffett believe most stocks are either overvalued or undervalued.
To determine the real value, value investors usually ignore the stock price and look at the entire company. Value investors will examine a company’s sales data, its financial reports, holdings, real estate, patents, intellectual property, research and development, and many other factors.
The dream of value investors is to find a good stock that the market dramatically undervalues. Thus, many value investors are bargain hunters who are seeking the most bang for their buck.
Many value investment strategies emphasize the intrinsic or real value of stocks. A popular value formula is to calculate the amount of cash a company generates. To determine the intrinsic value, investors examine a wide variety of metrics.
Value investment flies in the face of many modern notions about capitalism. Many value investors reject the efficient market hypothesis and believe the markets are usually inefficient and inaccurate.
Another popular belief of value investors is that investment industry professionals and the media cannot be trusted. These investors think the only reliable information about a company is the financial data. They ignore everything else.
A classic value investing strategy is to seek companies that have a share price that is way below the intrinsic values per share. Followers of this strategy believe that the stock price will rise over time to reflect the real value of the company.
Most value investors are focused on the company fundamentals; this means they focus on the financial reports, income statements, balance sheets, etc. Essentially, there are numbers of people who use financial data to help them estimate intrinsic value. Value investing is often confusing because there are many such financial metrics and calculations.
The value gurus add to the confusion by emphasizing different sets of numbers and factors. Warren Buffett emphasizes the future free cash flow as one of the company’s most important criteria. Buffett’s teacher Ben Graham, however, emphasized the ability of a company to consistently generate dividends for its investors.
Most value investors practice a buy and hold investment strategy. In buy and hold, a person purchases a stock and keeps it for a long time.
The classic value investing idea is that you will not lose money on a stock that holds its intrinsic value. The universal value investing challenge is to identify the low-priced undervalued stocks with high intrinsic value.
Most value investors can be considered contrarians because they assume popular wisdom about stocks is wrong. An excellent way to think of value investing is that it is the belief the market is always wrong.
The Origin of Value Investing?
The most famous value investors of all time include the father of value investing Benjamin Graham and Warren Buffett. Buffett is widely considered the greatest investor of all time.
Value investors believe that the stock market continually undervalues companies, and therefore this undervaluation represents an opportunity. The more undervalued the company is, the higher the margin of safety. The margin of safety is the difference in the market capitalization of the stock and its actual intrinsic value.
What is Value Investing According to Benjamin Graham?
The British-American investor and economist Benjamin Graham is widely viewed as the father of value investing.
Graham first laid out his principles of value investing in his 1934 textbook Security Analysis. Graham popularized value investing with his 1949 classic stock investing book, The Intelligent Investor.
Both books are based on stock investing lessons Graham, and others taught in a popular course at Columbia Business School in New York City. The Intelligent Investor first outlined what is now widely viewed as value investing.
The Intelligent Investor teaches Graham’s most influential ideas, including Mr. Market and group investment. Mr. Market was Graham’s characterization of the stock market.
Graham liked to describe the stock market as a lunatic named “Mr. Market” who sold stocks at insane prices. The key to making money in Graham’s view was to catch Mr. Market when he was selling valuable shares at low prices.
Graham’s approach is based on the theory that the market is inherently irrational. Mr. Market was Graham’s way of explaining that notion to ordinary people.
One of Graham’s primary teachings is that investors need to evaluate stocks for their ability to make money. Graham’s definition of a good company is one that generates lots of cash.
Graham’s definition of a good stock was an equity that generates high dividends.
Graham believed the ability to make money is the only criteria by which you should judge stocks. The man’s philosophy is best summed up by his first rule of investing. When faced with new stock, Graham advised investors to ask, “does it make money.”
Graham’s second rule of investing was to “see rule number one.” The ability to make money is the essential attribute of any investment in Graham’s teaching.
To identify such stocks, Graham invented what he called the group approach. In the group approach, you identify criteria for undervalued stocks and search for equities that meet that criteria.
Graham attracted attention for claiming that stocks picked with his group approach gained value at twice the rate of the Dow Jones. The Dow Jones Industrial Average was the most popular stock index in the 20th Century.
Graham was an active investor who worked on Wall Street for decades. Graham was openly critical of the stock market, most investors, and corporations.
Today Graham is best known as the primary teacher of his most famous pupil, Warren Buffett. Buffett studied under Graham at Columbia Business School and worked at Graham’s company, the Graham-Newman Partnership, early in his career.
Graham’s influence extends far beyond amateur value investors. Many mutual funds employ Graham’s strategies of diversification, group investment, portfolio management, and financial analysis in their stock picking.
The critical criteria of a Graham value investment are that a company needs to be cheap and make a lot of money. This simplicity is what makes Graham’s value investing so popular.
Many investment professionals, however, view Graham’s ideas as too limited for today’s complex markets.
What is Value Investing According to Warren Buffett?
Warren Buffett is the most successful and famous value investor in the world for good reason.
Buffett is widely admired because he was the world’s third-richest man on September 30, 2019. Forbes estimates Buffett had a personal fortune of $82.1 billion on that day. Most of that fortune comes from stock in Buffett’s company Berkshire Hathaway (NYSE: BRK.A). Much of Berkshire Hathaway’s money comes from its stock holdings, which Buffett helps pick.
Buffett bases his value investing on Graham’s philosophy, but he employs different tactics and criteria. Unlike Graham, Buffett is willing to pay higher prices for companies he considers suitable.
Buffett will buy more expensive stocks that meet his criteria. His portfolio has contained some expensive stocks, including Apple (NASDAQ: AAPL), at various times.
Another difference between Warren and Graham is that Buffett will buy large amounts of what he considers good stocks. Buffett’s strategy is to concentrate his investment in money-making equities.
Buy companies with strong histories of profitability and with a dominant business franchise. Warren Buffett
When he analyzes a stock, Buffett pays the most attention to a company’s cash flow and assets. Buffett’s core belief is those good companies always have lots of cash.
One difference between Buffett’s approach and Graham is the Oracle of Omaha’s focus on growth. Buffett will pay extra for companies with a healthy rate of growth like Apple.
Berkshire Hathaway will sell companies with a slow rate of growth. Buffett sold much of his stake in Walmart (NYSE: WMT) in recent years because of that company’s low growth rate.
Another Buffett belief is that investors need to keep large amounts of cash on hand. Berkshire Hathaway made headlines for accumulating $122.38 billion in cash and short-term investments in summer 2019.
Investors need lots of cash so they can take advantage of opportunities fast, Buffett teaches. Investors also need money to cover emergency expenses and to borrow against.
Like Graham, Buffett is a contrarian famous for his skepticism of the market, the media, investors, and the investment industry. Buffett dismisses investment fads, popular wisdom, professional fund managers, and new technologies.
In recent years, Buffett has become increasingly critical of the wealthy and the American political system. Buffett pledged to give 99% of his fortune to charity to encourage the rich to give back.
Buffett is a celebrity who has achieved rock-star status among investors. CNN claims over 16,200 people attended Berkshire Hathaway’s carnival-like shareholders’ meeting in Omaha, Nebraska, in May 2019. One highlight of the shareholders’ meeting is a public question-and-answer session where Berkshire Hathaway stockholders can ask Buffett anything.
Buffett’s value investing combines Graham’s philosophy with a contrarian view of the markets and a cynical view of human nature. Buffett likes to tell people to buy companies so simple “even somebody’s idiot nephew” can run them. The notion being that “somebody’s idiot nephew” will be in charge at some point.
Buffett’s value formula is hard to calculate manually because it emphasizes several divergent criteria.
Unlike most investors, Buffett emphasizes a cash flow and rate of growth over the share price.
Buffett does not take a lot of risks in his investing. He makes substantial investments in stable, simple businesses, including insurance, consumer goods, retail, finance, and media.
Buffett’s methods are not for everybody because of the time it takes for profits to be made, emphasizing long-term stable profits. Too many people are focused on short-term trading to make money, which is much riskier. Many people, however, swear by Buffett and his investing wisdom.
[Related Article: 10 Simple Steps To Finding Undervalued Stocks]
Further Reading: The Intelligent Investor. Benjamin Graham.
The Pros & Cons of Value Investing
Value investing is a well-proven strategy that is clearly evident in the success of Warren Buffett and the Berkshire Hathaway Group.If you cannot decipher company accounts and devote the time to researching companies in detail, you will not be successful. Read more about screening for great value investments.
You may find a good company, but its share price may not move for years.
Average trade duration
Long-Term – Years
The effort to maintain the strategy
High – lots of research required, unless you use a great stock screener.
Low to medium