What is value investing?

Value investing is probably the purest form of contrarian investing out there, says John Stepek. But what exactly is it, and how do you go about it?

Below is an excerpt from John Stepek's book on contrarian investing, The Sceptical Investor.

Value investing is probably the purest form of contrarian investing out there.

The value investor makes money by understanding the true value of an asset, then buying or selling when the market’s mood swings offer 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.”

The question is: what is it, and how do you go about it?

The value investing equation

Value investing involves two core concepts: intrinsic value, and margin of safety. Intrinsic value is what you – the value investor – believe an asset is truly worth. Margin of safety is the gap between its intrinsic value and the price you would feel comfortable buying it at (in order to give you sufficient upside, and to limit the downside if you are wrong).

So, boiling it down to a very simple equation, a value stock can be considered to be one where:

Current market price < (intrinsic value - 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 and person to person.

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. This was largely 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 notes 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 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 – 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.”

How Buffett quit smoking cigar butts

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.

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.”

• For more on this topic, and many others to do with contrarian investing, you can grab a copy of John’s book here.

Recommended

Cryptocurrency roundup: authorities tighten the screw
Bitcoin & crypto

Cryptocurrency roundup: authorities tighten the screw

Saloni Sardana looks at the cryptocurrency stories that caught our eye this week.
21 Jan 2022
Stockmarket crash: is the “superbubble” heading for a “superbust”?
Stockmarkets

Stockmarket crash: is the “superbubble” heading for a “superbust”?

America's Nasdaq stock index is down by more than 10% after soaring to all-time highs in a "superbubble". Are we about to see a "superbust" stockmarke…
21 Jan 2022
Inflation: now we really have something to worry about
Inflation

Inflation: now we really have something to worry about

We’ve been worrying about a sharp rise in inflation for years, says Merryn Somerset Webb – now, we finally have something to worry about.
21 Jan 2022
Share tips of the week – 21 January
Share tips

Share tips of the week – 21 January

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
21 Jan 2022

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022