This way of investing dates back about 100 years but remains to this day a highly regarded strategy with proven results. Benjamin Graham, American economist and investor is the original creator of value investing. However, it was not until 1934 with the publication of his book 'Security Analysis' that his investment theory was made known to the general public.
The book was a real 'game-changer' for the time because of the logical and rational way in which the investment process was mapped out. Graham (and co-author David Dodd) were the first to separate investing from speculating, until then there was precious little structure or consistency in the way investment decisions were made.
The duo of Warren Buffet and Charlie Munger are undoubtedly the most well-known supporters of value investing. Their tremendous successes are part of the reason for the popularity of this value approach.
Simply put, the value investor specifically looks for companies whose market value (stock price) is lower than their current intrinsic value.
Some key terms in value investing that are important:
By comparing this intrinsic theoretical value with the current market value, it can be determined which companies are over- or undervalued.
Value investors focus on stocks that are undervalued because they expect the price to rise again since the company is worth more than the current market price (based on the calculated intrinsic value). The greater the difference between the (lower) market value and the (higher) intrinsic value, the more interesting the stock becomes for the value investor.
Yet it does not stop here. After all, it is not that stock prices will automatically rise because the current market price is lower than the calculated intrinsic value. In order to value the future real value of a company, one will also have to look at the expected growth and revenue, the profit development, the value of the brand, the general entrepreneurial climate and the quality of the management... Determining the intrinsic theoretical value is only one - admittedly important - part of a more detailed and complex way of assigning a specific future value to a company.
However, there are also subjective elements that need to be taken into account. For example, how do you value a "brand name" or "the quality of its management"? In what way do you take into account "changing market conditions" or "new social trends" that may have an impact on the company?
Precisely because there are many pitfalls and assumptions when valuing the real value of a company, value investors build in a Margin of Safety into this investment strategy. It acts as a kind of buffer between the intrinsic value and the prevailing market price. How much that Margin of Safety should be is different for each investor. Moreover, the accuracy of the Margin of Safety used is highly dependent on how well you can determine the intrinsic value of a company....
An example: Suppose you have determined the fair value for company X at $50 and you use a margin of safety of 25%. The stock is currently quoted at $44. The fact that the current market value ($44) is lower than the fair value you have calculated ($50) indicates at least that we are dealing with an undervalued stock. However, with the margin of safety used, you may only buy this stock at a maximum price of $37.5. ($50 -25%).
Now, for the sake of simplicity, let's assume that the stock did indeed sag a bit further and your limit price was hit. So you bought shares of company X at $37.5. 18 months later, the stock is trading at $43 and you find that your previously calculated growth forecast was too optimistic and the current market value is more or less equal to the fair value. However, because you took into account a margin of safety when buying (shares bought at $37.5), you still realize a profit of almost 15% (current value at $43).
If you had not used that margin and simply bought the shares when they were quoted at $44 while you had calculated an intrinsic value of $50, you would have been confronted 18 months later with a share price that was quoted $1 lower ($43).
Such a margin of safety gives a little more flexibility in terms of the accuracy of your calculation of the actual value.
This has everything to do with investor sentiment and the general stock market climate. Price fluctuations in a stock price (especially for the short term) never reflect the true value of a company. Moreover, it is impossible to measure sentiment and emotions, something that is possible for the actual value of a company up to a certain point and with the necessary safety margin. That is also why value investing should always be considered in the long term. In doing so, even as a value investor, do keep in mind that irrational stock prices can last much longer than your ability to be patient....
Just like the overbought and oversold zones of technical indicators, the concepts of 'undervalued' and 'overvalued' offer no assurance that the price will rise or fall. Price is still determined in the short term by supply and demand and not by actual value. As a result, shares can fall far below their intrinsic value but, conversely, shares can rise far above their real value. So, as a value investor, don't be too quick to sell shares and take profits off the table just because they are quoting well above their intrinsic value. By doing so, you are almost certain to miss out on exceptionally large price gains.
Value traps occur when the share appears very cheap based on your calculation but where the real value is ultimately much less than what you had calculated. However, do not confuse this with shares that have fallen heavily in price for purely speculative (technical) reasons but whose fundamentals are still solid.
In this article we show you how to use ChartMill to get a first selection of value stocks that might be of interest.