Too embarrassed to ask: what is value investing?

When you start investing, one of the first concepts you’re likely to encounter is “value investing”. But what exactly is it?

When you start investing, one of the first concepts you’re likely to encounter is “value investing”. Like many terms in investment, “value” is not easy to pin down precisely.

As Charlie Munger, the business partner of famous US investor Warren Buffett, put it: “All investment is value investment, in the sense that you're always trying to get better prospects than you're paying for.” This is true, but not very helpful. So let’s be more specific.

At the heart of value investing lies the idea that a company’s share price is often very different to its “intrinsic value”. This disparity is often driven by market mood swings rather than rational analysis. So a value investor calculates the “intrinsic value” of a company, and then looks to invest when its share price is below that. A value investor also looks for a “margin of safety”. That is, they want to invest when the company is not just a little bit, but a great deal cheaper than its intrinsic value, in case their assumptions are wrong.

How do you calculate intrinsic value? By analysing a company’s accounts. Traditionally, value investors look particularly closely at the assets on a company’s balance sheet – its book value. The idea is that if a company trades for a lot less than the value of the assets it owns, then in theory, you could buy the company, shut it down, sell all its assets, and still profit.

There are two big risks for value investors. One is that they buy companies which will never regain their past glory. For example, some companies only look cheap because their business models have been destroyed by new technology. These are known as “value traps”.

The second risk is summed up in the apocryphal quote from John Maynard Keynes, who as well as being the 20th century’s most famous economist, was also a brilliant investor. As Keynes said: “The market can remain irrational for longer than you can remain solvent.” In other words, sometimes even good quality value stocks remain out of favour for longer than the average investor can endure holding onto them, in the face of massive underperformance. This highlights the most important trait for the value investor: patience.

For more on value investing, subscribe to MoneyWeek magazine.

Recommended

Should you buy Vodafone shares, or steer clear?
Share tips

Should you buy Vodafone shares, or steer clear?

Vodafone grew revenue by 4% and profit by 11% last year, and offers investors a 6.4% dividend yield. So should you buy Vodafone shares? Rupert Hargrea…
17 May 2022
2021 Château La Mascaronne rosé: a work of art from Provence
Wine

2021 Château La Mascaronne rosé: a work of art from Provence

This wine soars above all others with its grace, refinement and impressively long finish
17 May 2022
The UK jobs market is still red hot – but will it last?
UK Economy

The UK jobs market is still red hot – but will it last?

For the first time ever, there are more job vacancies than people to fill them, and wages are rising at a decent clip. But that might just be a tempor…
17 May 2022
Melrose Industries: a British manufacturer that is well-placed for recovery
Share tips

Melrose Industries: a British manufacturer that is well-placed for recovery

Melrose, the aerospace and automotive manufacturer, has been hit by the pandemic, but the shares are unduly cheap says David J Stevenson.
17 May 2022

Most Popular

Get set for another debt binge as real interest rates fall
UK Economy

Get set for another debt binge as real interest rates fall

Despite the fuss about rising interest rates, they’re falling in real terms. That will blow up a wild bubble, says Matthew Lynn.
15 May 2022
High inflation will fade – here’s why
Inflation

High inflation will fade – here’s why

Many people expect high inflation to persist for a long time. But that might not be true, says Max King. Inflation may fall faster than expected – and…
13 May 2022
Is the oil market heading for a supply glut?
Oil

Is the oil market heading for a supply glut?

Many people assume that the high oil price is here to stay – and could well go higher. But we’ve been here before, says Max King. History suggests tha…
16 May 2022