In this beginners guide to value investing, I’ll explain the basics of how this investing strategy works. I’ll explain how to identify value stocks, how to apply the strategy and the downsides to value investing.
Value investing – a beginners guide
What is value investing?
Value investing is an investing strategy, also known as an investing style. Value investing can be compared to other investing styles such as growth investing, passive investing, small-cap investing or large cap-investing.
Any investing strategy translates into a set of criteria to apply to companies listed on the stock market when picking stocks & shares.
Investors following the value strategy are looking for companies which appear to be underpriced relative to their true value, known as ‘intrinsic value’.
The theory is a simple one; that the market doesn’t always price companies fairly at all times, but that eventually, pricing will correct itself. Value investors believe that an underpriced company won’t be underpriced forever.
Therefore a value investor seeks to take advantage of this temporary mispricing by searching for companies which appear to be trading at a bargain share price.
Value investors will then buy and hold value companies in the expectation that the gap between the company’s price and its true value will narrow over that time, providing an extra element of return in addition to the normal return expected from holding a portfolio of shares.
Introduction to value investing
The value investing approach is widely credited to Benjamin Graham, an economist and investor who formulated this approach between the 1920s and the 1950s. Being part-academic, Graham generously published his ideas in two notable investing books which are still bought and read today by students of the value investing approach:
These value investing books, and in particular The Intelligent Investor, laid down the foundations of what we now regard as common sense when investing in shares. He wrote about concepts such as:
- The risks of heavily indebted companies
- Buy and hold investing for the long term
- Fundamental analysis
- Only buying with a margin of safety
- Contrarian investing
Each of these points is a building block of the value investing approach, so we’ll cover these in more detail below.
How to apply the value investing approach
Value companies are those which appear to be cheaper than they should be. In other words, their market value is much lower than the intrinsic value of the company would imply it should be.
You’ll notice that value is a relative concept. Without referencing the intrinsic value and its market value, you cannot conclude whether a company is a value stock.
This is critically important, as this means that you cannot expect to pick value stocks by simply honing in on details about the business in isolation.
For example: a company may have successfully increased its revenues by 50% year on year for a decade. This tells us a lot about the intrinsic value of the company – this is clearly a strongly performing business.
This sales data does not, however, help us understand whether the company is good value, until we look at the relative price of its shares.
If its share price has increased in line with its sales, then we have little basis to conclude that the business is a bargain. If however, the share price has fallen over the same period, we may now begin to build a good case to buy its shares.
This is a trivial example, which I hope helps to illustrate that value investing isn’t necessarily about buying the ‘best businesses’ or the ‘best management teams’. A share will only hit a value investors radar when its merits are strong, and its pricing appears low.
Reduced price does not always equate to good value
This principle of relativity also applies in the opposite direction. A value investor will not make an investment on the basis of pricing in isolation either.
Looking for value is not the same as looking for companies with recent dips or crashes in their market value. A fall in the price of a company does not equate to good value, as many factors could lead to a fall, such as:
- A negative public relations incident
- The obsolescence of their product by a competitor
- A surprisingly poor set of financial results being announced
These factors would likely hit the share price, and the intrinsic value of the underlying business. That is a fair change in pricing, not necessarily the creation of a bargain.
Applying the ‘margin of safety’
Margin of safety is a rule which value investors apply to increase their discipline when looking for value stocks.
The margin of safety is the size of the gap between the intrinsic value and the share price. The wider this gap, the higher total profit potential from a narrowing of the gap.
But perhaps more importantly, a high margin of safety means that the gap doesn’t have to close completely, for the investor to still see a profit.
This is very important because of the inefficiency of the markets. As I stated above, value investing makes an assumption that pricing anomalies are eventually fixed. That being said, pricing gaps can remain bargains for years, leaving the value investors who hold their shares no better off. In practise, a small level of mispricing may never correct itself.
This is why value investors only invest in a company when the pricing gap is greater than their margin of safety.
Benjamin Graham’s preferred margin of safety was allegedly ⅓. This meant that he would only invest if the market price of a security was at a 33% discount to his estimate of its intrinsic value.
This would mean that if the price of a share returned to its full value, he would have made a return of 50%. But it would also mean that he could see a healthy return if the share price only moved halfway to its intrinsic value.
Different investors will place a different value on companies because:
- They place different weighting on different characteristics
- They may disagree on what will likely happen in the future
- They may have different personal financial circumstances which will impact the amount they can afford to pay for an asset.
The subjectivity of valuation means that your intrinsic valuation might be very different to the rest of the market. If this is the case, then the likelihood of the share price ever reaching your calculated figure might be close to nil.
By applying a margin of safety, you give some room for error, and still allow for a profit even if, in hindsight, you had overvalued the business.
How to pick value stocks & shares
We’ve been talking a lot about intrinsic value and now it’s time to look at how this is calculated by value investors in practise. How do investors quickly determine when a company is good value or not?
The answer is that most value investors will look at a combination of financial metrics. Where a company looks good on all of these measures, they’ll then perform a more qualitative review to check that a nightmare isn’t lurking behind the rosy figures.
Value investing financial metrics:
Price to earnings (P/E) ratio:
The price to earnings ratio is a formulae which reveals how much the market is willing to pay for each £1 of company profit.
A company trading at a P/E ratio of 15 is worth approximately 15 times its most recent annual profit.
For reference, the FTSE 100 index of UK large-cap companies has an average P/E which has ranged from 11 – 22 in recent years.
As the P/E ratio shows how much investors are willing to pay for profits, a low P/E ratio implies that the company is a better value buy, as you’re getting the same profit for a lower price.
In reality, a low P/E ratio may be caused by a poor outlook for the company (and thus its earnings, will soon reduce). This means that the P/E ratio can often flatter poor businesses with negative trending earnings. A value investor who only invests in companies with rock-bottom P/E ratios could find themselves with a portfolio of struggling businesses which barely make any earnings at all after a few years.
Price to book ratio
Companies are universally valued at the present value of all of their expected future distributions to shareholders, through dividends or share buybacks. In effect – shareholders pay a price now, because they place a specific value on the future payments they expect to receive as a shareholder.
However when the outlook is bleak, this can cause the value of a business to actually fall below another important metric – its book value.
The book value of a company is the accounting value of its assets, minus its liabilities. In a simplistic way, you could argue that the book value is a very rough approximation of what a company could raise in cash by selling off all of its assets.
While few companies would commit corporate suicide in such a way to deliver a premium return to investors (at the expense of the workforce), this nuclear option nethertheless means that the book value of a company can be seen as a ‘pricing floor’.
In theory, the market value of a company should not fall below its accounting value. Therefore, value investors look at the ratio between the book value reported in its financial statements, and the market value of the company.
The devil is in the detail, as accounting value is not always a perfect approximation of realisable value i.e. the amount that could actually be raised through disposals. For example,
- Some assets are quite intangible and only derive their value through use in future years. Tax incentives are an example. To a company selling itself off, this asset may not be transferable to a new buyer, and would be effectively wasted.
- Specialised businesses may struggle to find a willing buyer for large assets such as heavy machinery. It could also be prohibitively expensive to transport it to a new location. This means that the recoverable value of these assets would be far less than their book value.
Debt to equity ratio
The debt to equity ratio of a company measures the value of its debt (one type of funding) against the value of its shares (another type of funding).
A small amount of debt is not a bad thing. In fact, due to the deductibility of interest payments on corporate tax returns, the cost of debt is effectively ‘subsidised’ by the government.
This has resulted in many profitable and cash-rich companies, such as Apple Inc to engage in financial engineering. They take on some debt and use it to enhance their returns to shareholders.
However, debt becomes quite toxic to a company’s prospects once it reaches a critical level. Unlike dividends, interest payments cannot be deferred or cancelled during times of financial difficulty. Debt holders, such as banks, are also able to legally step in and seize assets as required if a company has breached conditions set out in the loan agreement.
For this reason, value investors like to review the debt to equity ratio to help screen out businesses which are being strangled by their borrowings. This is particularly important, as many debt-heavy businesses will have low P/E ratios and low price to book ratios because they make the markets nervous.
Value investing qualitative characteristics
When a value investor has identified companies which appear to be good value on the basis of financial metrics, they will perform fundamental analysis before investing in the company.
Fundamental analysis involves stepping back and reviewing the performance of the business in its own context. It’s about asking questions such as:
- Does the company have an effective management team?
- Does the business have a good track record?
- Does the business have a dominant and defendable position in its market segments?
- Does the business possess a competitive advantage which is likely to persist?
A qualitative review should include looking at the company’s latest annual report and looking at news about the company over the years. This should allow you to reach a conclusion as to whether the attractive financial metric scores have been caused by weakness in the business, or whether they do not appear to be justified.
Warren Buffett openly discussed one way in which he approaches this analysis in the 1995 Berkshire Hathaway AGM.
In his own words:
“What we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.
[…] But we are trying to figure out what is keeping — why is that castle still standing? And what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?” – Warren Buffet, speaking in Omaha in 1995
What Warren is describing cannot be revealed by a single metric or any amount of number crunching. It’s a piece of analysis that can only be performed by a human taking a look at a companies performance over time and reaching a qualitative conclusion.
Is value investing a successful strategy?
You may be surprised at the answer to this simple question.
In the long run, value investing has been a successful strategy. Warren Buffett, one of its more ardent and consistent followers, is regarded as one of the greater investors of all time. This highlights merits in the approach.
However, this anecdotal glory is pulled into sharp contrast with recent data which shows that value companies have significantly underperformed growth companies over the last 30 years. This can be seen clearly in the following chart from FE Analytics which plots the performance of these competing approaches, as tracked by MSCI, an indexing company.
Source: FE Analytics
The Financial Times also reported the following chart which covers a long time horizon and still reaches the same sobering conclusion:
You will notice that the majority of the outperformance has occurred in the last few years. To followers of recent stock market bright stars such as Google, Facebook, Apple, Netflix, Amazon and Tesla this should come as no surprise. These are all highly-valued growth companies, and would never fit into the value investing approach due to their sky-high valuations compared to their earnings.
So, what does this mean for the value investing approach? Is value investing dead? Has it become the victim of its own success? After all, if hordes of investors begin chasing companies with the same financial metrics, this leaves no ‘bargains’ left on the table for a new investor.
The answer is very unclear. In the world of financial markets, financial cycles tend to play out over time frames of between 5 – 10 years. That the value investing approach has underperformed for several cycles is a difficult truth to ignore.
This implies that whether in boom, or in bust, the share prices of apparently ‘underpriced’ value stocks have not performed as well as the stock market in general.
Value investors are known to be contrarians. They intentionally put their money in ‘out of fashion’ stocks, and attempt to buck the trend and score returns by buying low and selling high.
For an investor today, you could argue that the ultimate contrarian play is to engage in value investing at all.
Being down on its luck for 30 years, the strategy is as unpopular as ever. For die-hard value investors, this only makes it all the more attractive. Convinced of a longer-term rebound, many are convinced that the time for value investing is now.
Their view is that as the valuation of technology companies enters bubble territory, what better time could there be to place your money in companies which show good value?
Examples of value investing funds (UK)
Rather than picking value stocks yourself, you could choose to invest in cheap UK equity exchange-traded funds which follow a value investing approach.
Each fund will have a slightly different methodology and strategy to pick their stocks, therefore look online for their prospectus (or even better – an interview with the fund manager themselves) to understand how they design their portfolios.
In the UK, value investing funds tend to contain ‘value factor’ or just ‘value’ in their fund name. Examples include:
- iShares Edge MSCI World Value Factor UCITS ETF GBP
- Vanguard Global Value Factor UCITS ETF (VVAL)
I hope you’ve found this beginners guide to value investing useful.