What is Value Investing?

Copyright © 2006 Geoff Gannoncalculated value. Surprisingly, this fact alone separates
What is Value Investing?value investing from most other investment
Different sources define value investing differently.philosophies.
Some say value investing is the investmentTrue (long-term) growth investors such as Phil Fisher
philosophy that favors the purchase of stocks thatfocus solely on the value of the business. They do
are currently selling at low price-to-book ratios andnot concern themselves with the price paid, because
have high dividend yields. Others say value investingthey only wish to buy shares in businesses that are
is all about buying stocks with low P/E ratios. You willtruly extraordinary. They believe that the phenomenal
even sometimes hear that value investing has moregrowth such businesses will experience over a great
to do with the balance sheet than the incomemany years will allow them to benefit from the
statement.wonders of compounding. If the business' value
In his 1992 letter to Berkshire Hathawaycompounds fast enough, and the stock is held long
shareholders, Warren Buffet wrote:enough, even a seemingly lofty price will eventually
"We think the very term 'value investing' isbe justified.
redundant. What is 'investing' if it is not the act ofSome so-called value investors do consider relative
seeking value at least sufficient to justify the amountprices. They make decisions based on how the
paid? Consciously paying more for a stock than itsmarket is valuing other public companies in the same
calculated value - in the hope that it can soon be soldindustry and how the market is valuing each dollar of
for a still-higher price - should be labeled speculationearnings present in all businesses. In other words,
(which is neither illegal, immoral nor - in our view -they may choose to purchase a stock simply
financially fattening)."because it appears cheap relative to its peers, or
"Whether appropriate or not, the term 'valuebecause it is trading at a lower P/E ratio than the
investing' is widely used. Typically, it connotes thegeneral market, even though the P/E ratio may not
purchase of stocks having attributes such as a lowappear particularly low in absolute or historical terms.
ratio of price to book value, a low price-earningsShould such an approach be called value investing? I
ratio, or a high dividend yield. Unfortunately, suchdon't think so. It may be a perfectly valid investment
characteristics, even if they appear in combination,philosophy, but it is a different investment philosophy.
are far from determinative as to whether an investorValue investing requires the calculation of an intrinsic
is indeed buying something for what it is worth and isvalue that is independent of the market price.
therefore truly operating on the principle of obtainingTechniques that are supported solely (or primarily) on
value in his investments. Correspondingly, oppositean empirical basis are not part of value investing. The
characteristics - a high ratio of price to book value, atenets set out by Graham and expanded by others
high price-earnings ratio, and a low dividend yield - are(such as Warren Buffett) form the foundation of a
in no way inconsistent with a 'value' purchase."logical edifice.
Buffett's definition of "investing" is the best definitionAlthough there may be empirical support for
of value investing there is. Value investing istechniques within value investing, Graham founded a
purchasing a stock for less than its calculated value.school of thought that is highly logical. Correct
Tenets of Value Investingreasoning is stressed over verifiable hypotheses; and
1) Each share of stock is an ownership interest in thecausal relationships are stressed over correlative
underlying business. A stock is not simply a piece ofrelationships. Value investing may be quantitative; but,
paper that can be sold at a higher price on someit is arithmetically quantitative. There is a clear (and
future date. Stocks represent more than just thepervasive) distinction between quantitative fields of
right to receive future cash distributions from thestudy that employ calculus and quantitative fields of
business. Economically, each share is an undividedstudy that remain purely arithmetical. Value investing
interest in all corporate assets (both tangible andtreats security analysis as a purely arithmetical field
intangible) - and ought to be valued as such.of study. Graham and Buffett were both known for
2) A stock has an intrinsic value. A stock's intrinsichaving stronger natural mathematical abilities than
value is derived from the economic value of themost security analysts, and yet both men stated
underlying business.that the use of higher math in security analysis was a
3) The stock market is inefficient. Value investors domistake. True value investing requires no more than
not subscribe to the Efficient Market Hypothesis.basic math skills.
They believe shares frequently trade hands at pricesContrarian investing is sometimes thought of as a
above or below their intrinsic values. Occasionally, thevalue investing sect. In practice, those who call
difference between the market price of a share andthemselves value investors and those who call
the intrinsic value of that share is wide enough tothemselves contrarian investors tend to buy very
permit profitable investments. Benjamin Graham, thesimilar stocks.
father of value investing, explained the stockLet's consider the case of David Dreman, author of
market's inefficiency by employing a metaphor. His"The Contrarian Investor". David Dreman is known as
Mr. Market metaphor is still referenced by valuea contrarian investor. In his case, it is an appropriate
investors today:label, because of his keen interest in behavioral
"Imagine that in some private business you own afinance. However, in most cases, the line separating
small share that cost you $1,000. One of yourthe value investor from the contrarian investor is
partners, named Mr. Market, is very obliging indeed.fuzzy at best. Dreman's contrarian investing
Every day he tells you what he thinks your intereststrategies are derived from three measures: price to
is worth and furthermore offers either to buy youearnings, price to cash flow, and price to book value.
out or sell you an additional interest on that basis.These same measures are closely associated with
Sometimes his idea of value appears plausible andvalue investing and especially so-called Graham and
justified by business developments and prospects asDodd investing (a form of value investing named for
you know them. Often, on the other hand, Mr.Benjamin Graham and David Dodd, the co-authors of
Market lets his enthusiasm or his fears run away with"Security Analysis").
him, and the value he proposes seems to you a littleConclusions
short of silly."Ultimately, value investing can only be defined as
4) Investing is most intelligent when it is mostpaying less for a stock than its calculated value,
businesslike. This is a quote from Benjamin Graham'swhere the method used to calculate the value of the
"The Intelligent Investor". Warren Buffett believes itstock is truly independent of the stock market.
is the single most important investing lesson he wasWhere the intrinsic value is calculated using an analysis
ever taught. Investors ought to treat investing withof discounted future cash flows or of asset values,
the seriousness and studiousness they treat theirthe resulting intrinsic value estimate is independent of
chosen profession. An investor should treat thethe stock market. But, a strategy that is based on
shares he buys and sells as a shopkeeper wouldsimply buying stocks that trade at low
treat the merchandise he deals in. He must not makeprice-to-earnings, price-to-book, and price-to-cash
commitments where his knowledge of theflow multiples relative to other stocks is not value
"merchandise" is inadequate.investing. Of course, these very strategies have
Furthermore, he must not engage in any investmentproven quite effective in the past, and will likely
operation unless "a reliable calculation shows that itcontinue to work well in the future.
has a fair chance to yield a reasonable profit".The magic formula devised by Joel Greenblatt is an
5) A true investment requires a margin of safety. Aexample of one such effective technique that will
margin of safety may be provided by a firm'soften result in portfolios that resemble those
working capital position, past earnings performance,constructed by true value investors. However, Joel
land assets, economic goodwill, or (most commonly)Greenblatt's magic formula does not attempt to
a combination of some or all of the above. Thecalculate the value of the stocks purchased. So, while
margin of safety is manifested in the differencethe magic formula may be effective, it isn't true
between the quoted price and the intrinsic value ofvalue investing. Joel Greenblatt is himself a value
the business. It absorbs all the damage caused byinvestor, because he does calculate the intrinsic value
the investor's inevitable miscalculations. For thisof the stocks he buys. Greenblatt wrote "The Little
reason, the margin of safety must be as wide as weBook That Beats The Market" for an audience of
humans are stupid (which is to say it ought to be ainvestors that lacked either the ability or the
veritable chasm). Buying dollar bills for ninety-fiveinclination to value businesses.
cents only works if you know what you're doing;You can not be a value investor unless you are willing
buying dollar bills for forty-five cents is likely to proveto calculate business values. To be a value investor,
profitable even for mere mortals like us.you don't have to value the business precisely - but,
What Value Investing Is Notyou do have to value the business.
Value investing is purchasing a stock for less than its