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”. 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.