What Is Value Investing?

Summary: Value investing is widely regarded as the most successful investment approach. In large part, this relates to the long track-record that is available for scrutiny by some of the best minds in investment history. Whether it is for you or not, it is worth gaining an understanding in the logic and methods.

Depending upon how you view this approach to picking winners on the stock market, it is either a philosophy or a religion!

Value investing is the art of buying assets for less than their intrinsic value. This means that whilst you may pay $1 in the market, the actual underlying value of property, cash and other assets may be $1.50 or $2. At least that is the theory.

In times of high asset prices and rising markets, genuine value can be hard to find.

The theory, which is sometimes also referred to as contrarian investing, was championed by Benjamin Graham. In his book, The Intelligent Investor, Graham covers the subject and working methods in some depth.

However, Graham has long since passed away and the early versions of the book are literally decades old. Your author's copy is from the fourth revision which was carried out in 1973.

For obvious reasons, there are elements of the book which seem no longer relevant. The advance of computing power makes analysis far more accessable to the masses than in Graham's time.

Still, the impact of Graham's work is arguably as long lasting and important as that of Ralph Elliott and his wave theory.

But that could be a mistake to presume that it is all out of date. Ultimately, this is a mindset of waiting, pouncing and then waiting some more. It is a very professional approach suitable for strong characters and contrarian minds. Having a very good source of income helps too, since the last thing that a practitoner will want to do is to be forced into selling his holdings at the wrong time because of personal financial needs.

Financial legislation has also moved on meaning that an investor should be less in fear of a management team that 'cooks the books', though modern investors may utter the words 'Enron', 'Bre-X' or 'Hollinger' in response. There was also precious little regulation of companies and their annual reports which meant that a significant element of his work was about spotting companies that were being less than honest in their annual filings. With the SEC (in the US) and FSA (in the UK), these problems are much less of an issue for a modern investor.

Spotting unreliable accounting information was something that Graham specialised in, but what few regulations and accountancy standards there were were poorly applied in his time.

This balance sheet analysis - something that was a new concept in the stock market when he started practicing it - put Ben Graham well ahead of the pack of investors that he was competing with in the market. As might be imagined though, in times without analyst reports and 'market colour', it took painstaking hours of research to find a company whose fundamentals appeared to fit the selection criteria being used. Then, the company had to be selling at a price he found attractive - that might take months or years of waiting for an opportunity.

In short, value investing requires the investor to be hard working, patient, careful, of strong mind and deep pocket! It is not for everyone...

Three words

One of the core ideas, as mentioned above, is that of value for money - getting more in real assets than the price being paid. These assets are often referred to as intrinsic value. That way if the company goes bust, there will still be something for shareholders. Other elements that appear on a balance sheet, such as goodwill, will be difficult to cash in.

This concept is now better known as margin of safety. Warren Buffett calls these the three most important words in investment. Depending upon how they are applied, they represent the core of the value investing criteria - the search for undervalued stocks. 

The harsh reality though is that in a world of excessive debt and company borrowings, mutual funds and pension funds, there is a lot more money invested in the stock market than there was in Graham's time. This means that most of the time there are very few - if any - companies available that fit the criteria of trading at or below book value. That said, every time the world thinks that valuations are crazy, Warren Buffett seems to pick up a spectacular bargain to be added to the Berkshire Hathaway portfolio.

Out of sight

Typically, Buffett is investing on the NYSE and not on some far-flung developing economy where people are not looking, suggesting that there will always be opportunities on Wall Street for those patient enough to look. Often these opportunities come in the form of defensive stocks while the world is focusing on the latest technical innovations and speculations.

As might seem obvious, exceptional value for money is unlikely to be found amongst the latest hot stocks that fund managers have labelled as growth stocks. Instead, the value for money is typically found in yesterdays industrial sectors that have reliable but overlooked business models.

Should there be a bear market in full swing, then the likelyhood of finding bargains is much greater, however, the fear associated with the times will often stop people from buying good businesses at these opportune moments. It is this clarity of thought and certainty of  mind that is needed by a contrarian investor.

Why? Because the risks that the undervalued stocks that your patient research have unearthed might still drop and drop in price with the rest of the stock exchange are high. This is where bravery is required.

There are, of course, a number of books that lay out the value investing criteria of people like Graham and Buffett, as well as software packages that help to select value stocks and even newsletters and subscription services dedicated to this area. The most obvious books to start with are The Intelligent Investor and Security Analysis by Graham and Buffettology by Mary Buffett. These books lay out some of the important thinking processes and investment criteria that they used to find cheap stocks.

The following pages will take a brief tour of the analysis and thinking required to become successful using this approach:

What Are The Value Investing Basics?

Problems With The Value Investing Approach

The Value Investing Rules Of Ben Graham

The Good And Bad Of A Value Investing Strategy

What Is Asset Stripping?

Value Investing With Warren Buffett

Value Versus Growth Investing