What is Value Investing?
Value Investing is an investment approach where investors seek out stocks of companies that are trading in the market at a price that does not agree with its intrinsic or inherent value. Value Investing consists of two primary concepts – undervaluation and overvaluation. Value investors consider a stock to be undervalued when it is trading at a price lower than its intrinsic value. On the other hand, when a stock is trading at a price higher than its intrinsic value, investors consider such stock to be overvalued.
Value investors carry their belief that share prices do not justify the long-term fundamentals of a company because such prices are considerably dependent on market behavior. They employ a contrarian investment approach by denying reacting as per market tendencies and moving in the opposite direction as the market.
Basically, Value investors are looking for companies on cheap valuation metrics, usually with low multiples of their assets or profits, for reasons which are not justified over the longer term. They believe the market tends to overreact to positive and negative news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. This inadequacy allows profiting by purchasing stocks at discounted prices. Value investor needs to have a great deal of patience; a contrarian mindset and a long-term investment horizon for this type of investment approach.
How does Value Investing work?
The principle behind value investing is – purchase stocks when they are undervalued or on sale, and sell them when they reach their true or intrinsic value, or rise above it. Another condition which value investors follow is allowing for a margin of safety when trading in value investing stocks. Stock prices can change owing to several reasons, underlined by a popularized market tendency that causes a share’s price to waver from its intrinsic value.
Top value investors refrain from partaking in such market tendencies and ferrets for stocks of companies that have sound long-term fundamentals. Still, due to several contributing factors, their prices are lower than their inherent value.
Value investors seek companies with long-term potential but temporary downtrends in share prices due to market biases. Such investors analyze several parameters and bank on multiple financial metrics to determine which company is performing below its capacity in the market.
Intrinsic Value of a financial asset
Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the current trading market price of that asset.
Intrinsic value is an umbrella term with useful meanings in several areas. Most often the term implies the work of a financial analyst who attempts to estimate an asset's intrinsic value through the use of fundamental and technical analysis.
There is no universal standard for calculating the intrinsic value of a company, but financial analysts build valuation models based on aspects of a business that include qualitative, quantitative and perceptual factors.
Qualitative factors—such as business model, governance, and target markets—are those items specific to what the business does. Quantitative factors found in the fundamental analysis include financial ratios and financial statement analysis. These factors refer to the measures of how well the business performs. Perceptual factors seek to capture investors’ perceptions of the relative worth of an asset. These factors are largely accounted for by means of technical analysis.
Creating an effective mathematical model for weighing these factors is the bread-and-butter work of a financial analyst. The analyst must use a variety of assumptions and attempt to reduce subjective measures as much as possible. In the end, however, any such estimation is at least partly subjective. The analyst compares the value derived by this model to the asset's current market price to determine whether the asset is overvalued or undervalued.
Some analysts and investors might place a higher weight on a corporation's management team while others might view earnings and revenue as the gold standard. For example, a company might have steady profits, but the management has violated the law or government regulations, the stock price would likely decline. By performing an analysis of the company's financials, however, the findings might show that the company is undervalued.
Benjamin Graham- Father of Value Investing
Benjamin Graham, also known as the father of value investing was a British born American economist professor and a great investor. He is famous for his book “The Intelligent Investor” where he introduced the concept of value investing. Today value investing is considered as one of the best investment strategies. His work in managerial economics and investing has led to a modern wave of value investing within mutual funds, hedge funds, diversified holding companies, and other investment vehicles. Modern great or we can say the king of Value Investing Mr. Warren Buffet considers Benjamin Graham as his idol.
In 1914 Benjamin Graham completed his graduation from Columbia University and started working at Wall Street. Where he cultivated a sizable personal nest egg over the next 15 years. But unfortunately, he lost most of his money during the great depression period in 1929.
Those experiences taught Graham lessons about minimizing downside risk by investing in companies whose shares traded far below the companies' liquidation value. In simple terms, his goal was to buy a dollar's worth of assets for $0.50. To do this, he utilized market psychology, turning market fears to his advantage. These ideals inspired him to write "Security Analysis" (published in 1934), which chronicled his methods of analyzing securities. Later on, he introduced the concept of margin of safety. The margin of safety is an investment concept which says you should buy a stock when its prices below are the conservative valuation of the business. According to Graham do companies share price I will come to you at its intrinsic value one day. In simple words, we can say that purchasing clothes at discount. In 1949 Graham introduced his book “The Intelligent Investor” probably the most famous book of Benjamin Graham. After reading this book Warren Buffett became a disciple of Benjamin Graham later on Warren Buffett started working with Benjamin Graham at Graham company coldest Graham Newman company.
Fundamental Analysis vs Value Investing
Value investing is an investment strategy wherein stocks are picked in case they are being traded less than their intrinsic value. Value investing works on the assumption that the stocks that are chosen are being underestimated by the investors, and the company has huge potential to grow in the near future.
Fundamental Analysis on the other hand works on the fundamentals of detailed analysis of both its quantitative and qualitative factors. Quantitative factors include the company’s current position in terms of its assets, availability of cash and cash equivalents, capital invested in the company by its owners etc. It also includes determining various financial and accounting ratios such as P/E ratio (price earnings ratio), EPS (earnings per share), inventory turnover ratio, acid test ratio etc. Moreover, it also comprises of qualitative factors such as how efficient communication is there between the senior management and its juniors, governance of the company, stakeholder satisfaction etc.
In order to determine the intrinsic value of a stock, qualitative factors such as good governance, target markets, and quantitative factors such as financial and accounting ratios are taken into consideration. Hence, regardless of the approach being followed by a long-term investor, one has to be aware of the company.
It pays attention to market reactions to current events and to which companies pay dividends. This leaves some companies undervalued based on their long-term growth potential. It shows the health of the company.
Fundamentals are thus of two types- quantitative and qualitative
Quantitate fundamentals involves hard numbers, that is, quantifiable or measurable data regarding the business. It includes things like financial statements and prices. Investors who use fundamental analysis believe that a stock price reflects the per-share value of all future cash flows of a company discounted to the present value. Fundamental analysts use quantitative information from a company’s financial statements to make their investment decisions. The statements include balance sheet, income statement and cash flow statements.
A balance sheet records the assets, liabilities and equity of a company at a particular point.
The income statement is used to measure the profit and loss of a company over a given timeframe. An income statement shows data about the revenue and expenses that a business generates from its operations within a given time. Investors can use the income statement and growth rates to project out a company's earnings over time. This is the objective of the traditional method of fundamental analysis.
When it comes to the cash flow statement, it represents information about the cash inflows as well as outflows over a given time. The cash flows focus on activities such as cash from investing- which is the cash a business uses to invest in assets and the proceeds obtained from the sale of its equipment, long term assets or other businesses it owns- or cash from financing – which is the cash the company pays or receives from borrowing or issuing of funds- or operating cash flow – which is the cash the business generates from its day-to-day operations.
Fundamental analysts look at the cash flow statement because it is difficult for an entity to manipulate or alter its cash situation.
With qualitative fundamentals, they are intangible and difficult to measure. These include characteristics such as the management of a company, the quality of the key executives, patents, brand-name recognition and proprietary technology. In qualitative fundamentals, analysts look at factors such as the business model, the competitive advantage, the management and corporate governance. The business model of a company gives an idea about its position in the market, hence its stock value. Also, the long-term success of a company may be driven by its ability to ensure a competitive advantage and maintain it.
Even a business with the best model may not survive if the leaders fail to execute the plan properly. The policies a company puts in place may determine the health of the business environment.
In qualitative fundamentals, it is also crucial to consider outside factors. This includes the industry of the company, market share, customer base, competition, industry growth and business cycles. Understanding how the industry of the company works also allows the investor to gain insights into the current and future financial health of the company.
The stock market works more on rumors rather than actual growth, no matter how good the company’s potential is in terms of its assets, one wrongdoing by the CEO, could lead to a significant fall in the stock price of that company. However, value investing ignores the factor of market orientation. There have been many instances in the past where the share price of a company had fallen due to the top management being involved in unethical practices, however, its intrinsic value still stood strong. Whereas in technical analysis, market orientation is a huge qualitative factor.
Technical analysis also helps in comparing a company to another and has a wider scope in terms of long-term investors, traders, high risk investors, safe investors etc. Technical analysis is applicable for long-term investing as well as short term investing. Moreover, technical analysis does not restrict an investor and does not guide anyone to consider the intrinsic value. For instance, if the stock’s market price is higher than the intrinsic value, and the investor analyses the company’s financial position and thinks that the stock can go up even further, technical analysis does not stop him to invest in that stock. However, value investing limits the scope of an investor. It follows the fundamentals of investing in a financial asset in case it is valued lower than its intrinsic value.
Why is fundamental analysis being used more? Is it better than value investing?
Determining the intrinsic value of a stock is in itself a very difficult task. Most investors are not aware of how to find a stock’s intrinsic value. The intrinsic value of the stock has a huge assumption on its head. It assumes the fundamentals of the company right now will also be in the near future, however, there is a possibility that the assumption could turn out to be false. However, if one was able to find the intrinsic value of a stock, it is difficult to say how accurate it would be. The intrinsic value of the stock is very subjective in itself, long term investors take qualitative factors such as good governance, how much a company invests in its long-term assets, whereas short term traders give more importance to the behavior of the stock.
Value investing follows a rigid approach of investing in the stock when its market value is less than the intrinsic value, however, technical analysis is not the same. It allows investors to decide their stock based on their preference. For example, some stocks are good for the long run, whereas some stocks are good for short run, but value investing gives us no information regarding this.
One of the key factors that value investing ignores is a company’s performance during the time of global downfall or recession. For example, in the year 2008, the financial assets of the whole world had fallen, in that casec value investing does not determine which stocks to invest in as the trading price of all stocks is below its intrinsic value.
Value investing might give us information about an undervalued stock, but it cannot determine whether the stock would fall in the near future. This means people who do short selling or bid against the stock do not require value investing.
Undervalued shares worth investing in are difficult to identify. Estimating the intrinsic value requires a certain level of expertise and not every investor has it. Even if they do, there are a lot of things beyond investors’ control like changes in management and behavior of peers. You can analyze all the fundamentals but there’s no guarantee you’ll make the right decision.
Need for hard work and Patience
Value investing is not for everyone and it is not the easiest stock market strategy to implement, so you must be willing to do your homework to be successful. Learning to evaluate a business requires both time and effort, and waiting to see the results of all your hard work will entail a great deal of patience. Those who want to reap the benefits quickly may find it challenging. Sometimes proponents of this strategy have to hold their positions for years until the market sentiment changes in their favor. But in the end, patience may bring a high reward.
The pitfalls of waiting
Having ownership in a value company can be fruitful, but it can equally be a dead end. Value traders can hold stocks for a lifetime but never see them turn around. In such a no-win situation, investors are forced to quit with a loss.
Need for an investor’s mindset and Rowing against the stream
With value investing, there is no room for emotions. Value investing requires self-confidence meaning that you’ll have to go against the flow. In a sense, value investors are very similar to contrarians. At least both of the styles are based on looking for price discrepancies and acting against the prevailing sentiment. Anyway, to see your investments bringing hardly any returns is quite a pressure.
Value traders may invest in all sectors that underperform now but are predicted to turn around in the future. This is how value investing proponents saw bank shares in 2009. However, committing funds to several sectors only means that a portfolio is poorly diversified, thus exposed to substantial risks.
Difficulty in estimating intrinsic value
Probably the biggest downside of value investing is the challenge of accurately estimating a company’s intrinsic value. There are a number of different methods that investors can use to accomplish this task, but all of them require a certain level of expertise to master, and not every investor has a solid background in finance.
In determining how to value a stock, you’ll be looking at all the information that’s available about a given business, including its past and projected revenues, earnings, debt, and cash flows. But even hard data such as these can’t always effectively account for such intangible and unpredictable factors as changing management styles and evolving market competition. In the end, it will come down to your own skill in research, analysis and judgment for deciding whether or not a company’s stock is undervalued, and subsequently worth buying.
Some of the successful Value Investors in the world
As the head of Boston-based Abrams Capital Management, founded in 1999, David Abrams has built a hedge fund with over $10 billion worth of assets under management. Abrams has been able to perform better than most fund managers by realizing an annualized net return of 15% for investors in the funds’ first 15 years.
Abrams fund is unlevered, it doesn't invest with borrowed (leveraged) funds, and it maintains a lot of cash of hand. A look into Abrams’ Capital of August 2019 filing reveals that the firm held a very concentrated portfolio of $3.68 billion with very large stakes in each of its holdings. Abrams’s large holdings in terms of value, comprising 42% of the portfolio, were Celgene Corp. (CELG) (17% of the portfolio), PG&E Corp. (PCG) (15% stake) and Franklin Resources (BEN) (9%).
Mohnish Pabrai sold his IT business for more than $20 million in 1999. Pabrai launched Pabrai Investment Funds, an investment firm that was modeled after Buffett’s investment partnerships, between 2000 and 2018 Pabrai has been able to realize a cumulative return of more than 900% for investors. His portfolio concentrates on India and emerging nations, as he doesn't find many mispriced or under-valued stocks in the U.S. market. As of 2020, Pabrai Investment Funds manages $674.5 million in assets.
Allen Mecham founded Arlington Value Capital Management. With over 1.4 billion in assets under management, Mecham executes a value investing strategy for his clients, makes about one or two trades a year, holds anywhere from six to 12 stocks in his portfolio. His major positions, as of August 2019, are in Berkshire Hathaway (BRK.B)— Buffett's company occupies 30% of the portfolio—and Alliance Data Systems (ADS) (13%). In 2012, it was reported that investors who invested with Mecham a decade earlier would have increased their capital by 400%.
Co-Chief Executive Officer of the Markel Corporation (MKL), a reinsurance business that has a similar business model to Berkshire Hathaway Tom Gayner is in charge of investing activities for Markel, including managing its float. The float is the funds provided by policyholders that are held before Markel’s insurance subsidies making claim payments. Overall, Gayner manages over $5.3 billion. His strategy is to allocate funds into a large portfolio of businesses (140 stocks as of 2020) that are undervalued by the market. He values companies with good management first and foremost, favoring large-cap, global ventures. Since its IPO in 1986 through 2014, Markel increased its book value by 20% each year.
Lee-Chin borrowed half a million dollars and invested it in only one company. Four years later, the value of his shares increased sevenfold. He sold those shares and used the profit to acquire a small mutual fund company that he grew from $800,000 in assets under management to more than $15 billion before he sold the company to Manulife Financial.
He believed in 5 rules/laws that every wealthy investor follows:
own a concentrated portfolio of high-quality businesses.
understand the businesses in their portfolio.
use other people’s money prudently to create their wealth.
ensure that their businesses are in industries with strong, long-term growth.
hold their businesses for the long-term.
Today Lee-Chin is the Chairman of Portland Holdings, a company that owns a diverse collection of businesses throughout the Caribbean and North America. His mantra is “buy, hold and prosper”. As of May 2020, his net worth is $1.6 billion.