Different sources define value investing
differently. Some say value investing is the investment philosophy that
favors the purchase of stocks that are currently selling at low
price-to-book ratios and have high dividend yields. Others say value
investing is all about buying stocks with low P/E ratios. You will even
sometimes hear that value investing has more to do with the balance
sheet than the income statement.
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
We think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Buffett's
definition of "investing" is the best definition of value investing
there is. Value investing is purchasing a stock for less than its
calculated value.
Tenets of Value Investing
1) Each share of stock is an ownership interest in the underlying business.
A stock is not simply a piece of paper that can be sold at a higher
price on some future date. Stocks represent more than just the right to
receive future cash distributions from the business. Economically, each
share is an undivided interest in all corporate assets (both tangible
and intangible) - and ought to be valued as such.
2) A stock has an intrinsic value. A stock's intrinsic value is derived from the economic value of the underlying business.
3) The stock market is inefficient.
Value investors do not subscribe to the Efficient Market Hypothesis.
They believe shares frequently trade hands at prices above or below
their intrinsic values. Occasionally, the difference between the market
price of a share and the intrinsic value of that share is wide enough to
permit profitable investments. Benjamin Graham, the father of value
investing, explained the stock market's inefficiency by employing a
metaphor. His Mr. Market metaphor is still referenced by value investors
today:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
4) Investing is most intelligent when it is most businesslike.
This is a quote from Benjamin Graham's "The Intelligent Investor".
Warren Buffett believes it is the single most important investing lesson
he was ever taught. Investors ought to treat investing with the
seriousness and studiousness they treat their chosen profession. An
investor should treat the shares he buys and sells as a shopkeeper would
treat the merchandise he deals in. He must not make commitments where
his knowledge of the "merchandise" is inadequate. Furthermore, he must
not engage in any investment operation unless "a reliable calculation
shows that it has a fair chance to yield a reasonable profit".
5) A true investment requires a margin of safety.
A margin of safety may be provided by a firm's working capital
position, past earnings performance, land assets, economic goodwill, or
(most commonly) a combination of some or all of the above. The margin of
safety is manifested in the difference between the quoted price and the
intrinsic value of the business. It absorbs all the damage caused by
the investor's inevitable miscalculations. For this reason, the margin
of safety must be as wide as we humans are stupid (which is to say it
ought to be a veritable chasm). Buying dollar bills for ninety-five
cents only works if you know what you're doing; buying dollar bills for
forty-five cents is likely to prove profitable even for mere mortals
like us.
What Value Investing Is Not
Value
investing is purchasing a stock for less than its calculated value.
Surprisingly, this fact alone separates value investing from most other
investment philosophies.
True (long-term) growth investors such as Phil Fisher focus solely on the value of the business.
They do not concern themselves with the price paid, because they only
wish to buy shares in businesses that are truly extraordinary. They
believe that the phenomenal growth such businesses will experience over a
great many years will allow them to benefit from the wonders of
compounding. If the business' value compounds fast enough, and the stock
is held long enough, even a seemingly lofty price will eventually be
justified.
Some so-called value investors do consider relative prices.
They make decisions based on how the market is valuing other public
companies in the same industry and how the market is valuing each dollar
of earnings present in all businesses. In other words, they may choose
to purchase a stock simply because it appears cheap relative to its
peers, or because it is trading at a lower P/E ratio than the general
market, even though the P/E ratio may not appear particularly low in
absolute or historical terms.
Should such an approach be called
value investing? I don't think so. It may be a perfectly valid
investment philosophy, but it is a different investment philosophy.
Value investing requires the calculation of an intrinsic value that is independent of the market price.
Techniques that are supported solely (or primarily) on an empirical
basis are not part of value investing. The tenets set out by Graham and
expanded by others (such as Warren Buffett) form the foundation of a
logical edifice.
Although there may be empirical support for
techniques within value investing, Graham founded a school of thought
that is highly logical. Correct reasoning is stressed over verifiable
hypotheses; and causal relationships are stressed over correlative
relationships. Value investing may be quantitative; but, it is
arithmetically quantitative.
There is a clear (and
pervasive) distinction between quantitative fields of study that employ
calculus and quantitative fields of study that remain purely
arithmetical. Value investing treats security analysis as a
purely arithmetical field of study. Graham and Buffett were both known
for having stronger natural mathematical abilities than most security
analysts, and yet both men stated that the use of higher math in
security analysis was a mistake. True value investing requires no more
than basic math skills.
Contrarian investing is sometimes thought of as a value investing sect.
In practice, those who call themselves value investors and those who
call themselves contrarian investors tend to buy very similar stocks.
Let's
consider the case of David Dreman, author of "The Contrarian Investor".
David Dreman is known as a contrarian investor. In his case, it is an
appropriate label, because of his keen interest in behavioral finance.
However, in most cases, the line separating the value investor from the
contrarian investor is fuzzy at best. Dreman's contrarian investing
strategies are derived from three measures: price to earnings, price to
cash flow, and price to book value. These same measures are closely
associated with value investing and especially so-called Graham and Dodd
investing (a form of value investing named for Benjamin Graham and
David Dodd, the co-authors of "Security Analysis").
Conclusions
Ultimately,
value investing can only be defined as paying less for a stock than its
calculated value, where the method used to calculate the value of the
stock is truly independent of the stock market. Where the
intrinsic value is calculated using an analysis of discounted future
cash flows or of asset values, the resulting intrinsic value estimate is
independent of the stock market. But, a strategy that is based on
simply buying stocks that trade at low price-to-earnings, price-to-book,
and price-to-cash flow multiples relative to other stocks is not value
investing. Of course, these very strategies have proven quite effective
in the past, and will likely continue to work well in the future.
The
magic formula devised by Joel Greenblatt is an example of one such
effective technique that will often result in portfolios that resemble
those constructed by true value investors. However, Joel Greenblatt's
magic formula does not attempt to calculate the value of the stocks
purchased. So, while the magic formula may be effective, it isn't true
value investing. Joel Greenblatt is himself a value investor, because he
does calculate the intrinsic value of the stocks he buys. Greenblatt
wrote The Little Book That Beats The Market for an audience of investors
that lacked either the ability or the inclination to value businesses.
You
can not be a value investor unless you are willing to calculate
business values. To be a value investor, you don't have to value the
business precisely - but, you do have to value the business.
Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at: http://www.gannononinvesting.com
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