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

Vaccines, value investing and UK stocks
Value investing

Vaccines, value investing and UK stocks

Vaccines promise a return to normal life. And that bodes well for “value” stocks, says Merryn Somerset Webb – and for the UK market in particular.
30 Nov 2020
The MoneyWeek Podcast: picking stocks is fun, but you need to do your homework
Investment strategy

The MoneyWeek Podcast: picking stocks is fun, but you need to do your homework

John Stepek talks to Steve Clapham, investor, analyst and author of The Smart Money Method, about the dangers in picking individual stocks and why you…
8 Apr 2021
How to find companies that can thrive in the post-Covid world
Advertisement Feature

How to find companies that can thrive in the post-Covid world

Many sectors of the global economy will return to something resembling pre-pandemic status, but others will take far longer to recover.
8 Apr 2021
What the Deliveroo IPO can teach us about investing
Investment strategy

What the Deliveroo IPO can teach us about investing

Losing money on an investment is painful, says John Stepek, but it can force us to look at our process in a way that making money doesn’t.
8 Apr 2021

Most Popular

Central banks are rushing to build digital currencies. What are they, and what do they mean for you?
Bitcoin

Central banks are rushing to build digital currencies. What are they, and what do they mean for you?

As bitcoin continues to soar in value, many of the world’s central banks are looking to emulate it by issuing their own digital currencies. But centra…
8 Apr 2021
House prices: from boom to even bigger boom
House prices

House prices: from boom to even bigger boom

UK house prices have risen to new to record highs, says Nicole Garcia Merida. Demand continues to outpace supply, but continued low interest rates, th…
9 Apr 2021
Nuclear power might never be popular – but now looks a good time to invest
Commodities

Nuclear power might never be popular – but now looks a good time to invest

Nuclear power gets a very bad press, but it is the ultimate renewable energy source. Interest in it is perking up again, says John Stepek. Which means…
9 Apr 2021