Editor's note: John's away this week so in place of your usual Money Morning, today we have an excerpt from his book on contrarian investing, The Sceptical Investor.
Value investing is probably the purest form of contrarian investing out there.
The efficient market hypothesis argues that the market price of an asset is always right. By contrast, value investors argue that the true value of an asset can be very different from the price that the market puts on it.
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The value investor makes money by understanding the true value of the asset, then buying or selling when an emotionally-driven market offers the opportunity to do so at an advantageous price.
As one of the best known and most successful value investors, Seth Klarman, puts it: "Value investing is at its core the marriage of a contrarian streak and a calculator."
So how do you do it?
The two most important concepts in value investing
Every value investor has their own preferred approach which is partly why, as with many aspects of investing, there are so many debates over what constitutes "true" value investing.
There are, however, two key concepts that are fundamental to value investing. And these are, I think, also key to understanding some misconceptions about value investing.
Value investing involves two core concepts: intrinsic value, and margin of safety.
The intrinsic value is what you the value investor believe an asset is truly worth.
The margin of safety is the gap between its intrinsic value and the price at which you would feel comfortable buying it (in order to give you sufficient upside, and also to limit the downside if you are wrong).
So boiling it down, a value stock can be considered to be one where:
Current market price < (intrinsic value less the percentage margin of safety required)
So if you think that the intrinsic value of a stock is £1, and you require a margin of safety of 30%, then you wouldn't buy until the market offered it to you at 70p or below.
This simple definition immediately flags up a couple of points about value investing.
Firstly, both of these measures are highly subjective. The calculation of intrinsic value can be done in lots of different ways and the margin of safety required will vary from situation to situation.
Secondly, value stocks are traditionally thought of as "bargain basement" stocks. But this definition makes clear that a stock doesn't necessarily have to be "cheap" based on simple ratio analysis, or even relative to the rest of the market, in order to be a bargain.
A stock could look quite expensive on some measures, but still represent good value, assuming that it is trading sufficiently below its estimated intrinsic value. Equally, a stock can be cheap without being a value stock it might be cheap for a reason, which is also known as a "value trap".
The evolution of value investing
Purists may not like this characterisation of value investing. But it reflects the evolution of value investing over the years. Benjamin Graham, Warren Buffett's mentor, is generally accepted as the father of value investing (his books, Security Analysis written with David Dodd and The Intelligent Investor, form the bedrock of the value canon).
Graham is often associated with buying distressed stocks, trading at rock-bottom levels. To a great extent, this was the result of Graham investing during the Depression era, when these sorts of opportunities abounded.
In 1932 he wrote a three-part series for Forbes magazine, in which he pointed out that almost a third of companies trading on the New York Stock Exchange were trading for less than the value of the cash (or easily liquidated assets) on their balance sheets. In other words, the pavements were scattered with $5 bills and investors were so terrified that they were ignoring them.
Graham was also an early proponent of index investing for investors who didn't have the time to dig for bargains, and suggested other techniques in line with an investor's level of experience. But regardless, it's the approach that we might call "deep value" that he's best known for.
And his most famous disciple, Warren Buffett, at first used similar techniques, or what he called "cigar butt" investing. Here's Buffett, writing in 1989:
"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.
"I call this the cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the bargain purchase' will make that puff all profit."
But what Buffett realised was that this is a high-risk approach to value investing. For a start, bad businesses tend to have bad luck they might look cheap today, but another problem is likely to be just around the corner. "Never is there just one cockroach in the kitchen", as Buffett puts it.
Also, you have to be alert to "flip" them quickly when you get the opportunity to take a profit. Otherwise your money is locked up in a dud business. Again, quoting Buffett: "Time is the friend of the wonderful business, the enemy of the mediocre."
So with the help and persuasion of his business partner, Charlie Munger, (and the ideas of Philip Fisher, author of another canonical investment book, Common Stocks and Uncommon Profits), Buffett moved on to a different model.
Buying great companies at good prices
Rather than trawl through the bargain bin looking for businesses that were worth more dead than alive, Buffett began looking for excellent businesses being sold at a discount to their intrinsic value. As he put it, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Some people describe this strategy as "growth at a reasonable price". But really it's just value investing given a rebrand (although it's also often abused as a great intellectual fig leaf for fund managers to justify their decisions to buy companies that are already popular).
You can see why buying quality assets at cheap prices might be more appealing than buying poor assets at bargain prices. There are fewer decisions involved one is a "buy-and-hold" strategy, whereas the other is a "buy-to-flip" strategy.
The trouble with cigar butts is that you always need to be finding more of them, and there aren't many around. Whereas if you can buy a decent company cheaply and then see your return compound up over and over again, then frankly it's less work.
There are also fewer risks involved in buying high-quality companies. The big risk with cigar butts is that the market is right: cheap stocks sometimes just keep getting cheaper, all the way down to zero.
John Maynard Keynes went through a similar intellectual journey to Buffett, when he moved from being a speculator to a value investor. "As time goes on", he wrote, "I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes."
The logic of value investing is hard to resist. And it's inherently contrarian. Why would an asset be trading for a lot less than its intrinsic value in a generally efficient market? Because the crowd has taken against it for irrational, behavioural reasons. Buy while it's out of favour, and you'll do well.
The obvious question then, is this: how do you calculate intrinsic value?
That's it for this extract if you'd like to read more, you can get 25% off your copy of The Sceptical Investor here.
