Overview – Understanding Value Investing
Although it’s not immediately obvious, almost all investors (“investor” as defined by Benjamin Graham) use or have previously used the principles of value investing in one way or another.
Value investing is the investment philosophy of many prominent investors such as Warren Buffett, Benjamin Graham, Irving Khan, Walter J. Schloss, Charles Brandes, Sir John Templeton, and Seth Klarman, to name a few.
Time and time again, value investing has proven to be a robust investment paradigm that has survived countless market manias (most notably the 1987 market crash and 2008-2009 financial crisis), investment fads (1980 junk bond craze, the dot-com bubble, mid-2000s mortgage-backed securities bubble), and many other vicissitudes.
Many books have been written about this topic, namely Security Analysis, The Intelligent Investor, and Margin of Safety, to name a few, and it is strongly recommended you go over these works.
This article is not an exhaustive analysis of value investing – the aforementioned texts have already done an exceptional job of doing that. Instead, this article will go over the history of value investing and some of its major tenets.
History of the Philosophy
Nearly all value investors agree that the individual responsible for developing and setting the foundations of the value investing philosophy is Benjamin Graham.
Widely considered as the “father of value investing”, Graham wrote two of the most influential texts in the field: Security Analysis (1934, co-authored with David Dodd) and The Intelligent Investor (1949) – the former was very academic in its writing style, whereas the latter appealed to a more general audience, but with the same rigorous principles and tenets.
Graham makes a very clear distinction between who qualifies as an “investor” and a “speculator”, and makes the argument for an investment style that focused on understanding a business’ operations (i.e., fundamental analysis), the separation of emotions when making investment decisions, purchasing securities below an “intrinsic value”, purchasing securities with a sufficient margin of safety, and adapting a contrarian mindset (more on these ideas later).
Graham, having lived through the Great Depression and both World Wars recognized that the “investing” habits of people at the time needed to be addressed with a more scientific approach.
Even in the early 20th century, Graham mentions how individuals would purchase securities without any sort of analysis beforehand and lacked any sort of comprehensive framework when purchasing securities, delegating their judgment and critical thinking to others – observations that can still be made today. Hence, value investing was born.
Security Analysis and The Intelligent Investor are the two works that detail Graham’s value investing philosophy, and both books remain classics to this day. Both texts were written in times where individual investors mostly dominated the market, high-quality information was difficult to access in a timely manner, hedge funds were just starting to take shape, and before the advent of myriad asset classes other than stocks and bonds.
Indeed, a lot has changed since Graham’s works were first published – many of the example companies he used don’t even exist anymore, and the industries he talks about are mostly neglected today (arguably no investor today would say the railroad or tobacco industry is booming).
Although the examples and specific circumstances are largely obsolete, the principles & major tenets are still relevant today. Wall Street remains just as greedy (if not more, with the advent of junk bonds, mortgage-backed securities, and countless financial derivatives), markets still occasionally misprice securities, and many people still falsely turn to investing as a get rich quick scheme.
Times have changed, yes, but principles transcend the boundary of time – that is why value investing remains relevant even today and continues to assist countless investors build sustainable and lasting fortunes.
Price is What Determines Investment Merit
Many individuals falsely believe that purchasing any sort of security is an “investment” – simply buying stocks, bonds, ETFs, or trust units is considered to be “investing” in some people’s eyes. However, there is a very clear distinction between investing and someone who simply purchases securities.
In Security Analysis, Graham and Dodd make it very clear that a security’s investment merit is a function of its price.
An enterprise’s investment merit is not an inherent trait by virtue of its brand strength, earnings power, and assets. How much an individual is willing to pay to lay claim to that brand strength, earnings power, and assets is what determines investment merit.
Price is the cornerstone of investing: an investor needs to know how much they need to pay to lay claim to the value an enterprise is providing. As Warren Buffett put it: “Price is what you pay, value is what you get.”
Value investing is the act of paying $50 and receiving $100 worth of value. Every value investor strives to determine that “intrinsic value”, and to pay considerably less than that figure.
Intrinsic Value
One of the central ideas behind value investing is the notion of intrinsic value. Intrinsic value can be thought of as the “true” price of a security.
For example, imagine you are purchasing a suit. Assuming the suit is bespoke, a lot of time, effort, and energy is needed to produce the final product. Upon completion of the suit, the price tag is $10,000.
At first, this price appears sensible: bespoke suits are some of the highest quality pieces of clothing produced, and they are made specifically for the user – surely the $10,000 price is a true reflection of that quality.
But what if you found out that the fabrics used were sourced from cheap producers, the tailor rushed the work, and comparable suits sold for much less? That $10,000 starts to become questionable.
Price and value are not the same things – just because a product or service is more expensive does not mean value increases at a commensurate rate.
You’ve probably heard the saying “you get what you pay for”, but when it comes to value investing, that isn’t necessarily true. Generally speaking, value tends to increase along with the price, but that relationship is far from linear.
This same principle of making the distinction between price and value applies to securities. Just because the stock of Company A is selling at $500 a share doesn’t automatically mean it’s more valuable than its competitor, Company B, whose stock is selling at $50 a share.
Value investors are interested in spending the least amount of money while getting the most value in return. The tricky part is assigning a monetary amount to that value.
The price that a security trades for at any given moment is its “market value” – the price that’s arrived at by the aggregate of the market’s emotions and the whims of supply and demand.
What value investors are interested in elucidating is a security’s “intrinsic value”: the value which an investor believes, based on thorough analysis, a security should be approximately priced as.
Graham and Dodd define intrinsic value as follows:
“…that value which is justified by the facts, e.g., the assets, earnings, dividends, [and] definite prospects, as distinct, let us say, from market quotations established by market manipulation or distorted by psychological excesses.”
Security Analysis, Sixth Edition, pg. 64
This definition may imply that intrinsic value is a precise figure which can be arrived at through some sort of elusive equation or formula, but that is not the case. Intrinsic value is not a precise measure but is more akin to a range in which a security’s price should fall within.
Graham and Dodd recognize that intrinsic value is imperfect, but is still useful when making investment decisions:
“It needs only to establish that the value is adequate – e.g., to protect a bond or justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price … [and] the degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased.”
Security Analysis, Sixth Edition, pg. 66 – 67
Graham and Dodd also explain the idea of intrinsic value in non-financial terms:
“It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his weight.”
Security Analysis, Sixth Edition, pg. 66
Again, determining intrinsic value is less of a precise calculation and more of an educated approximation.
Graham and Dodd understand that there are far too many factors, both quantitative and qualitative, that ultimately affect security prices so trying to arrive at a precise value is futile.
The idea of intrinsic value can be likened to confidence intervals in statistics: every real-world measurement (in this context, a precise intrinsic value) has some error associated with it, and arriving at the exact value with absolute certainty is near impossible. However, the range in which the true value falls in can be narrowed considerably by using confidence intervals – the higher the confidence level, the narrower the range.
Because of systematic error and experimental uncertainty, you’ll never know with 100% confidence what the “true” measurement is, so the best you can do is to narrow down the range where it might fall in as much as possible.
Intrinsic value is the same: knowing the exact price is not necessary; an investor only needs to know, with reasonable confidence, the range in which the price may fall in between.
Intrinsic Value and The Efficient Market Hypothesis
Graham and Dodd’s idea of intrinsic value stands in stark contrast to what is known as the Efficient Market Hypothesis (EMH).
EMH states that the price of any financial asset takes into account all available information, and the corollary made is that because every asset is priced with all relevant information in mind, it is impossible to purchase securities for less than some sort of “hidden” value, thereby rendering value investing moot.
Graham and Dodd challenge the EMH by arguing that the market does occasionally misprice securities and that these mispricings are caused by the short-term greed and untethered emotions of individuals and the market.
Graham and Dodd do not entirely dismiss the EMH, stating that the facts eventually reflect in security prices, but only in the long-term. Their argument is that short-term market swings do not automatically mean a business’ fundamental strengths have dramatically changed – a business’ stock price may be driven lower due to short-term factors, but it may still be an inherently strong enterprise that is simply being mispriced by the whims of the market.
This temporary mispricing, and taking advantage of it, is the basis of value investing.
Warren Buffett has been very vocal in his opposition to the EMH and continues to stand by his belief that markets will remain inefficient. Despite Buffett’s unmatched investment record, there are some academics (namely those who support the EMH) who still attribute his investment success to pure luck. His investment track record begs to differ.
Seth Klarman, an American billionaire, hedge fund manager, and a successful value investor in his own right, posits in his book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor that security prices fluctuate for two reasons:
- To reflect business reality (or investor perceptions of that reality)
- To reflect short-term valuation in supply and demand
This is not to say the EMH is something to be completely dismissed.
The wealth of information available to investors, the increasing role of computers and AI in investing, and armies of investors analyzing the same securities have no doubt played a part in making current markets more efficient than the ones Graham and Dodd were operating in.
Hundreds, if not thousands, of investors analyzing the same security will surely lower the probability of it experiencing a major mispricing.
However, there are some companies that investors overlook and therefore sell at a major discount, and the market does occasionally exhibit short-term mispricings. The market is more efficient, yes, but it’s still inefficient enough for value investors to operate in.
Arriving at an Intrinsic Value
Value investing, procedurally speaking, is actually quite simple: a value investor simply needs to purchase securities when they are selling below their intrinsic value and sell them when they approach or exceed their intrinsic value.
For example, an investor determines a company’s stock has an intrinsic value of approximately $100 (give or take $10 as a range) – it is currently selling for $40.
The investor should therefore purchase the stock (assuming all other quantitative and qualitative tests of investment merit have been satisfied); if the stock price is $95, or goes as high as $120, the investor should proceed to sell.
An investor should proceed to sell their securities if it approaches or exceeds the intrinsic value because beyond the upper intrinsic value limit the value is no longer justified by the facts. As the market value increases an investor will need to re-assess the intrinsic value to ensure they’re not holding an overpriced investment.
Although the process of purchasing securities below their intrinsic value and selling when they exceed it sounds easy, calculating intrinsic value isn’t so straightforward.
Graham refrains from presenting a rigid set of formulas or equations in both Security Analysis and The Intelligent Investor to prevent investors from falsely believing that intrinsic value can only be calculated a certain way, or that only certain metrics or ratios are worth studying. Recall that intrinsic value represents a price range calculated using the available facts.
Facts that one investor considers important may prove to be of less importance to another investor. Therefore, when value investors are presented with the same facts, chances are they will all calculate different intrinsic values.
This begs the question: which intrinsic value is correct? The answer is there is no “correct” value, only a value that makes sense to a specific investor based on their own analysis.
Warren Buffett remarked that he and his business partner, Charlie Munger, frequently calculate different intrinsic values for the same business despite using the same (or at least very similar) information.
One popular method to calculate intrinsic value is to use discounted cash flow (DCF). A discounted cash flow essentially estimates the cash (cash, not revenue) that a business is expected to generate in the future, then the present value of all future cash flows is found using an appropriate discount rate (for stocks, it is usually the desired rate of return or weighted cost of capital. For bonds, it is usually the coupon rate).
The sum of all future cash flows would serve as a basis for calculating intrinsic value. Of course, DCF is just one of many ways to determine intrinsic value.
Some investors choose to look for companies selling below their liquidation value (the value of a company after all assets have been sold, usually in a short time frame), or companies selling for less than their net working capital (net working capital = current assets – current liabilities).
Naturally, metrics such as Price-to-Earnings (P/E) and Price-to-Book (P/B) also have some weighting on intrinsic value.
Because intrinsic value can be calculated in so many ways and is an imprecise figure at best, this necessitates the existence of some “wiggle room” between the intrinsic value and market value to account for errors in the calculation.
Suppose an investor calculates an intrinsic value of approximately $80 for a stock currently selling for $75. Clearly, this investor must be very sure their calculation is correct because they are close to entering speculative territory. Graham and Dodd call this difference between intrinsic and market value the “margin of safety”.
Margin of Safety
Graham and Dodd were fully aware that the weakness inherent to intrinsic value was its inability to arrive at a precise figure.
They acknowledged that investing is as much of an art as it is a science, so expecting infallible results from data regularly intertwined with emotions and other subjective factors cannot reasonably be expected. In their words:
“In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or value well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove to be a satisfactory one.”
Security Analysis, Sixth Edition, pg. 703
A margin of safety is the difference between the intrinsic value and market value of a security. The wider the margin, the better.
Warren Buffett explains margin of safety in terms of tolerances: imagine coming across a bridge that’s designed to hold 30,000 pounds, but you insist on driving only 10,000-pound trucks across it, just to be safe. Driving a 29,995-pound truck across is really pushing it.
Intrinsic values are imprecise, so when purchasing a security, you want to make sure the price paid is well below the intrinsic value to minimize the likelihood of accidentally overpaying.
This is because even if the price of the security were to change, it would still be well within a price range considered investment-grade (as per an investor’s analysis).
There are no strict rules that dictate how wide the margin of safety should be, but general wisdom suggests that a wider margin is always desirable.
The concept of a margin of safety is so crucial because it makes up for the fact that valuation is imprecise; no value investor can say with absolute confidence that the intrinsic value they have calculated is correct, so some cushioning is needed in case mistakes were made or their estimates were a bit too optimistic.
The principles of intrinsic value and margin of safety are arguably the two defining elements of value investing, and these two seemingly simple tenets have served value investors well for several decades.
However, value investing is more than just applying a certain analytical framework: a certain mindset must also be embraced and mastered.
Adopting a Contrarian Mindset and Maintaining Unwavering Discipline
Value investing is essentially the act of looking for businesses that, despite having strong business fundamentals, are neglected by the general investing public, and as a result, are selling for less than what they are truly worth.
It is up to the value investor to calculate the intrinsic value and, along with other quantitative and qualitative factors, determine whether a given security has enough investment merit to be worth purchasing.
This all sounds very easy but, every investor is, at their core, an emotional being. Looking for bargains when others are making a quick (though albeit very speculative) gain and having the discipline not to succumb to speculation will, at times, prove to be challenging.
Undervalued securities are few and far in between – a value investor may sift through tens, if not hundreds, of different businesses and perform analysis on each, only to find out a certain security is overpriced or the company being analyzed has some hidden faults.
While a value investor works to find good deals, there will be times when the market is experiencing all-time highs, and speculators can make incredible gains just from buying the hot securities of the day.
This happened in the 1970s and 1980s when junk bonds offered double-digit coupon rates, in the 1990s and early 2000s where simply purchasing companies associated with the internet was enough to make any speculator an overnight millionaire, and in the mid to late 2000s when mortgage-backed securities seemed to provide an endless stream of cash flow.
In hindsight, these investment fads all withered away, leaving speculators with empty pockets and with value investors proving once again a disciplined approach is best.
While looking back at the mistakes of the past is easy, experiencing market euphoria first-hand and having the discipline not to get all caught up in the speculative excess is never easy for a value investor.
Adhering to a value-oriented investment philosophy also means constantly standing against the tide.
When markets are booming and are constantly in the green, value investors know that most securities are selling well above their intrinsic values and therefore present very few, if any, purchase opportunities despite so many individuals making spectacular gains.
Conversely, during the 2008 – 2009 financial crisis value investors needed to ignore the constant doom and gloom from every financial news outlet while continuing to search for good deals in a seemingly barren financial landscape.
Benjamin Graham, in The Intelligent Investor, urges investors not to view recessions or depressions as financial dead-ends, but instead as a market-wide sale for all securities. Of course, staying optimistic when an economy is in the doldrums is certainly not easy.
A value investor’s worst enemy is an overzealous market, while a battered economy and securities market is viewed as their best friend.
Even when markets are relatively stable, a value investor must not delegate their critical thinking to the whims of group-think or purchase a security after a cursory analysis simply because everyone else is doing so.
Although being a contrarian is a universal characteristic of value investors, Seth Klarman argues that having a contrary stance is not always needed. In his words:
“Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide….By contrast, when majority opinion does affect the outcome or odds, contrary opinion can be put to use.”
Margin of Safety, pg. 166
Contradicting popular opinion is, at many times, necessary for a value investor, but they must recognize when they are justified or whether they are simply being stubborn.
Not only is it hard to maintain a contrarian mindset but having the discipline to maintain a value-oriented investment approach no matter what is just as difficult.
In Margin of Safety, Seth Klarman makes a distinction between value investors and value “pretenders”: individuals who claim to adhere to the principles of value investing but will quickly abandon it at the first sign of trouble.
During the dot-com bubble, Warren Buffett was mocked for apparently missing out on an investment opportunity of a lifetime, with many speculators going as far as declaring value investing “dead”.
Fast forward a few years later, and those who mocked Warren Buffett and value investing were decimated when the bubble burst, while Buffett had the last laugh.
There have been many instances where the efficacy of value investing was called into question, but those who truly took value investing to heart continued to look for bargains, performed thorough analysis, and continued to make money while ignoring all the noise.
A great deal of discipline is also required to understand that a value investor does not need to have lots of great investment ideas and that investing success means holding a handful of truly outstanding investments. Warren Buffett explains this eloquently by using a baseball analogy.
In the 1997 Berkshire Hathaway letter to shareholders, Buffett likens value investing to a baseball player preparing to bat. Unlike baseball where strikes are called for failing to bat, in investing no such strikes are called.
A value investor can allow countless “pitches” to fly past them without even attempting to swing. An investor should only swing when a pitch falls within their “sweet spot” – that is, an enterprise that meets all the criteria to earn the title of a worthwhile investment.
This idea of letting hundreds of pitches go by stands in stark contrast to the approach made by institutional investors and speculators, who largely believe that they must purchase securities of as many enterprises as possible, even if they are not investment-grade.
A disciplined value investor knows only to swing when they are confident they will hit a home run.
Hard and Systematic Work Required
Sifting through hundreds of prospective enterprises, reading through the annual reports of companies that may be investment-grade, calculating intrinsic value, and studying qualitative factors takes a lot of time, patience, and hard work.
Indeed, Graham and Dodd address this reality:
“Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries? Mainly by hard and systematic work.”
Security Analysis, Sixth Edition, pg. 669
The main idea behind value investing is easy to understand, but successfully and consistently implementing it is very challenging.
Truly excellent bargains are rare to come across, so the only option left is to study enterprises one by one. Value investing may have created wealth for countless individuals, but by no means was that wealth obtained overnight.
Wrapping Up
Value investing was first introduced almost a century ago, and since then words fall short when it comes to properly describe the changes the global financial system has undergone.
Value investing still remains relevant today because its principles continue to withstand the test of time: markets still occasionally misprice certain securities, the advent of new financial instruments continue to push the boundaries of greed and speculation, and short-term emotional responses still throw the markets into disarray – all it takes is one piece of bad news for the markets to drop precipitously.
Because of these enduring realities, investors can still adopt a value-oriented philosophy and make a lasting fortune for themselves.
Details change, but principles are timeless. That is why value investing has worked in the past, continues to work today, and will likely continue to bring investment success to many more individuals in the near and distant future.
