What is Value Investing?
Value Investing involves the investment strategy of finding quality shares that are undervalued in the market by using an approximation of the stock’s value. The stock’s value (worth) is based on the performance of the company and a view of its future sustainable profitability, also known as normalised return on equity.
The stock market of today can almost be overwhelming with the multitude of different options thrust upon us all.
We are never forgetful of the old adage that “the best way to make money, is to not lose it in the first place”.
Many people think that the way to make money in the stock market is to buy shares at one price and to sell them at a higher price over the following days or weeks. However, prices are unpredictable and are often influenced by the irrational activity of market participants – many of whom are either undisciplined investors or consistently irrational. Trying to consistently second guess these people and the market, is futile. Sometimes you win and sometimes you lose.
Value Investing is commonly mentioned in discussion of the share market, but is not always understood. Value investing is not a new idea. In fact, we can trace its origins back to 1928 with Benjamin Graham & David Dodd. Graham and Dodd’s theory was hugely influential on several generations of investors, however became most famous when applied by one of the world’s most successful investors, US investor Warren Buffett.
Warren Buffett sums it up perfectly in his letter to Berkshire Hathaway shareholders, penned back in 1996.
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”
In his usual straight forward manner, Buffett aims to focus his investment efforts simply on company valuation and a well-considered appraisal of market prices. Not only does he seek out quality assets (businesses) that can be valued, he seeks to buy them at the right (cheap) price.
So, how do you choose the best shares to buy?
There are several ways.
You can try to find a stock with above-average growth in earnings, ideally when this trend is just beginning. This is called growth investing.
You can study the charts of a company’s price action and trading volume and try to infer from historical patterns and statistical indicators where the share price is headed. This is called technical investing – though it is more usually a short-term trading strategy.
You can read the business pages and back a ‘story’ about a company’s business prospects, without reference to fundamental financial data such as profits or dividends (which the company may not have.) This strategy needs a large helping of luck.
Or you can try to find quality shares that are undervalued in the market, using an approximation of the stock’s intrinsic value. This is value investing.
Value investing centres on intrinsic value. Intrinsic value is not a range of values, rather it is a precise assessment of a company’s value (worth) based on the performance of a company and a view of its future sustainable profitability, also known as normalised return on equity.
Share prices are pushed around by undisciplined or irrational market participants motivated by emotions, not considerations of value. A value investor should have a good idea of a company’s intrinsic value. The movements of the share price in the short term can create large discrepancies between the price and the investor’s estimate of value. This creates opportunity for the value investor and widens their margin of safety (difference between the intrinsic value of a stock and its market price) when buying.
A stock that is trading at a price below its intrinsic value obviously presents an opportunity to purchase, while one that is overpriced can be considered for a possible sale. Market sentiment can artificially inflate or depress that price, without affecting its actual value. Over time however, price should eventually come back in to line with that valuation (assuming that the valuation is done correctly).
The simple diagram below illustrates this investment strategy.
Whilst value investing is a simple concept – that doesn’t make it easy. Take shares. You invest your money in shares because you expect to get a better return than on other investments. History suggests a long-term investment in the share market does achieve this, however, higher the returns, often comes an increase in share price volatility and the risk of corporate failure.
From our Chief Investment Officer, John Abernethy, “on a day-to-day basis, value investing is all about sticking to your valuation process and turning off the ‘noise’ coming from the market”.
Welcome to the world of value investing.
Read more about Value Investing