The advantages of value investing

Value investing buying cheap shares, or shares that trade at less than their intrinsic value works. So why doesn't everyone do it? It comes down to the way people's minds work.

Lots of people want to buy and own the shares of great businesses. That's understandable. The trouble is, great businesses are often bad investments. That's because people know how good they are and so push the price of their shares up accordingly. Buyers then pay too much for them and get disappointing returns.

That's why value investors often have better results. By buying shares that are temporarily unloved at cheap valuations, they often make lots of money when things get better, because the upturn was not priced in when they invested.

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Of course, being a value investor is a lot more difficult in practice than in theory. Value investing has arguably changed too. When Benjamin Graham the father of value investing wrote the book Security Analysis in 1934 with the assistance of David Dodd, not many people were value investors.

The depression had made it relatively easy to find shares that were trading on low price/earnings (p/e) ratios, high dividend yields, or a long way below their asset values.

Today, there are thousands of professional investors with access to data and spreadsheets whocan quickly spot these types of shares. This means that not a lot of them exist. Shares that look cheap are cheap because they are bad businesses and deserve to be. These are known as value traps', where you can end up losing a lot of money.

To be a successful value investor now is not just about numbers, it's about understanding human behaviour and why shares prices become depressed. If you can grasp this, then you will stand a better chance of finding and profiting from stock market bargains.

You are your own worst enemy

To be a good value investor, you need to have the right mind set and not let your emotions get in the way of your decisions. This is far more important than knowing a lot about economics and finance. Yet it seems that lots of us just don't have such an outlook.

This is why people are always looking to get rich quickly by chasing hot initial public offerings, technology shares, small oil firms and penny shares.

It is also why lots of people buy shares after they have gone up, thinking they will keep on doing so, and sell them when they have gone down, fearing that their losses will get even bigger. Successful value investing is the opposite of this.

Go looking for trouble

Professional investors tend to fall prey to herd mentality. They fish in the same pond, buying and owning the same shares as their peer group. Most are scared of doing worse than their benchmark, such as the FTSE All Share index, so they don't veer from the herd too much.

Money managers will be afraid to buy the shares of firms that are in trouble. That's because if the investment doesn't pay off, they might look bad in the eyes of their customers. While this could deprive their clients of potentially good returns, it offers opportunities for others. The private investor doesn't have this problem and can afford to be patient.

If you're looking for stock market bargains, then you need to look for firms that are in temporary difficulties that they can recover from. The shares of these companies can be great investments because the market overreacts to their trouble. It has a habit of extrapolating recent trends into the future and prices the shares to remain in the doldrums forever.

So firms embroiled in scandals or litigation, that have temporarily depressed profits, too much debt, or where the chief executive has just left, can be fertile hunting grounds. In these cases there tend to be lots of people wanting to sell, but not that many wanting to buy.

This often drives share prices down to the point where there's room for management to make mistakes and for profits to disappoint, because the shares are already pricing in bad news. This is the margin of safety' that value investors look for.

Other things to look out for

On top of that, look for companies whose share prices have already fallen a long way, or are trading at 52-week lows. Alternatively, look for shares that are heavily shorted (where investors have borrowed shares and sold them in the hope of buying them back cheaper and pocketing the difference).

If things get better these positions will have to be covered quickly (or the short-sellers will lose huge amounts of money), which can lead to big gains in share prices.

You should also if possible compare share prices to ten-year average profits. This will tell you if a company is genuinely cheap, or just a cyclical low ebb. Struggling businesses on the verge of being reinvigorated can also be great contrarian investments.

A management team with strong incentives and a credible turnaround plan can lead to a share price gaining many times over.

Proof that it works

The last few years have worked out well for buyers of distressed or unloved companies the kind of company I look at in my gamble of the week' column. Not every share works out which is why you should buy a number of them to spread your risk but the gains can be impressive, as you can see in the table.