What actually is value investing? Those who have limited interest in the subject are likely to define it as the act of purchasing stocks that trade for less than their intrinsic value. However, there is a problem with this definition: “No rational investor admits to searching for securities selling for more than their underlying value. Everyone is looking to buy low and sell high.” (Greenwald et al., Value Investing: From Graham To Buffett And Beyond). With this inconsistency in mind, it seems that the aforementioned definition best describes all investing activities, instead of value investing in particular. Admittedly, it would be practical to have a simple, single sentence definition of the concept, but this is not the case. Instead, value investing – as originally conceived by Graham & Dodd in Security Analysis – describes the alignment of an investing process with the following three principles:
- A company’s market value and intrinsic value are distinct. The former is observable in the form of the stock price or market cap whereas the latter is subjectively determined by an analyst.
- Market value may fluctuate wildly, but the intrinsic value of a security, which is based on fundamental factors (balance sheet items, profit margins, etc.), remains relatively constant.
- Investors who purchase firms that trade at a significant discount to their intrinsic value are expected to achieve returns in excess of the market over the long-term. This discount between the quoted price and the intrinsic value is referred to as the margin of safety, and the wider it is, the better, as the investment embodies less risk relative to the potential reward.
To give further clarity as to what value investing actually is- and isn’t, let’s identify those groups of market participants who certainly are not value investors:
- Technical analysts. These traders ignore fundamental factors and instead analyse historical price and volume data for a given stock. Certain patterns in this data can signal future price movements, which is where the profit opportunity lies.
- Macro-fundamentalists. Investors in this group aim to understand the relationship between macroeconomic factors – such as interest rates, unemployment rates, or economic growth – and stocks, both as a whole and in specific sectors or industries. Such a top-down approach, which practically ignores company-specific fundamentals, does not match with the aforementioned principles.
- The majority of micro-fundamentalists. It is true that value investors analyse the fundamentals of individual stocks in a bottom-up fashion, just as other micro-fundamentalists do. However, whereas most micro-fundamentalists seek to forecast how a variety of variables (industry conditions, management shake-ups, earnings etc.) may affect the stock price of a firm, value investors focus on the price-fundamental relationship (the value proposition), which reveals the existence (or absence) of a margin of safety.
- Passive index investors. The mechanical purchase of those stocks which comprise a specific index does not constitute value investing. There are multiple reasons for this. Firstly, there is no margin of safety – on the surface, as index investors, we cannot know whether intrinsic value significantly exceeds market value. Secondly, the pure act of investing in an index fund implicitly embodies the assumptions of the Efficient Market Hypothesis i.e., that outperformance is impossible, since all relevant information is known by market participants and ‘baked’ into prices (of course, investors have plenty of valid reasons to invest in index funds, so they are unlikely to share this assumption explicitly).
It’s critical to interpret Graham & Dodd’s principles on a literal basis. Doing so will impress on you that value investing neither forbids investment in growth companies, nor state that statistical cheapness, such as low price-to-fundamental ratios, is synonymous with a margin of safety. Value is where you find it, and intrinsic value assessments, barring the inarguably objective net current asset value formula (an estimation of liquidation value), embody subjectivity. Some people were surprised that Warren Buffett invested in Apple, yet it turned out to be his most profitable investment ever, and it was entirely consistent with Graham & Dodd’s principles. In Buffett’s own words: “[value and growth] are joined at the hip” (Buffett’s Letter to Shareholders, 1992). In theory, value investors could sit at the same table, with one person pitching Netflix and another Imperial Brands PLC. Where modern value investors such as Joel Greenblatt and Tobias Carlisle differ is in their investment process – how they search for or value companies – but their allegiance to Grahamite principles remains solid.
Nonetheless, it is undeniable that the practice of value investing and immersion in related theory can foster certain traits and beliefs unrelated to foundational principles. For example, value investors have faith in the inevitability of long-term mean reversion. We are optimistic when valuing businesses in dire states, and pessimistic – sometimes excessively so – when it comes to valuing rapidly growing glamour firms, particularly in the field of technology. This can serve value investors well, but it can also result in missed opportunities – as rare as they are, certain companies deserve lofty valuations and successfully meet expectations. This subject was clearly addressed by Howard Marks in a recent memorandum, which I recommend reading.