Value Investing

Value investing is an investment strategy focused on identifying undervalued stocks, buying them, and holding them until their market price reflects their true intrinsic value. Rooted in fundamental analysis, this strategy prioritizes a company’s financial health over market trends and seeks to minimize risk through careful selection and long-term commitment.

Value investing is a disciplined, research-intensive approach that seeks to identify and invest in undervalued companies with solid fundamentals. While it requires patience and a long-term outlook, value investing has the potential to deliver substantial returns without being exceedingly risky. However, it’s not without its challenges, such as the risk of value traps and periods of underperformance. By focusing on intrinsic value, maintaining a margin of safety, and committing to a long-term perspective, value investors aim to achieve steady wealth accumulation over time. As with any investment strategy, thorough research, discipline, and continuous learning are key to succeeding in value investing.

Understanding Intrinsic Value

Intrinsic Value is central to value investing. It represents the perceived true value of a company based on its fundamentals—such as earnings, dividends, assets, and growth potential—rather than its current market price. Determining intrinsic value involves detailed analysis, including examining a company’s financial statements, understanding its business model, and assessing the quality of its management. Investors often use various valuation metrics like the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, and Discounted Cash Flow (DCF) analysis to estimate intrinsic value.

Margin of Safety

Margin of Safety is a key principle that involves buying stocks significantly below their intrinsic value to cushion against errors in valuation or unexpected market downturns. This concept, introduced by Benjamin Graham, ensures that even if the market doesn’t recognize the stock’s true value in the short term, the downside risk is minimized. The larger the margin of safety, the lower the risk of loss, making it a fundamental aspect of a conservative investment strategy.

Long-Term Perspective

Value investing is inherently a long-term strategy. Unlike traders who seek quick profits from short-term market movements, value investors are patient, often holding stocks for years until the market corrects its pricing. This long-term perspective allows value investors to ride out market volatility and benefit from the compounding of returns over time. Patience is a crucial virtue in value investing, as it often takes time for the market to realize the true value of a stock.

Of course, there are also risks associated with this. While a daytrader will close all positions before the trading day is over, a value investor put their money at risk over a very long period of time – and a lot of things can happen in that time. Over months and years, a company that used to have an excellent Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, Discounted Cash Flow (DCF) – and more – can take a turn for the worse. Sometimes it is due to factors within the company and sometimes due to factors outside it.

Focus on Fundamentals

Fundamental Analysis is the backbone of value investing. This involves a deep dive into a company’s financial health, examining factors such as revenue, earnings, profit margins, debt levels, and cash flow. Value investors also consider qualitative aspects, including the company’s competitive position, industry dynamics, and the quality of its management team. This comprehensive analysis helps investors identify companies that are not only financially sound but also have strong prospects for future growth.

Common Value Investing Strategies

Contrarian Investing: This strategy involves going against market trends by buying stocks that are out of favor with the broader market. These stocks may be undervalued due to temporary challenges, negative sentiment, or broader market downturns. Contrarian investors believe that the market often overreacts to bad news, creating opportunities to buy high-quality stocks at a discount.

Dividend Investing: Many value investors seek out companies that consistently pay dividends. Dividends are a sign of financial stability and profitability, providing investors with a steady income stream. Reinvesting these dividends can significantly enhance long-term returns.

Benjamin Graham’s Criteria: Benjamin Graham, considered the father of value investing, established specific criteria for selecting undervalued stocks. These include looking for stocks with low P/E and P/B ratios, strong earnings growth, and minimal debt. Modern value investors often adapt Graham’s principles to suit current market conditions.

Deep Value Investing: This involves seeking out stocks that are extremely undervalued, often trading at a significant discount to their intrinsic value. Deep value investors are willing to buy stocks that others may avoid, betting on their eventual recovery.

Risks of Value Investing

Value Traps: A value trap occurs when a stock appears to be undervalued based on its fundamentals but remains cheap or declines further due to underlying issues within the company. These issues might include poor management, declining industry conditions, or irreversible business challenges. Identifying and avoiding value traps is crucial for successful value investing.

Market Sentiment: While value investors rely on the market eventually recognizing a stock’s true value, this can take time—sometimes longer than anticipated. Market sentiment can remain negative for extended periods, requiring investors to have patience and confidence in their analysis.

Underperformance During Bull Markets: Value stocks may underperform during strong bull markets, where high-growth stocks often dominate returns. During these periods, growth investors might see higher short-term gains compared to value investors.

Notable Value Investors

Benjamin Graham
Benjamin Graham (1894-1976) was a British-born professor, financial analyst, and investor living in the United States. Known as the father of value investing, Graham laid the foundation for modern investment analysis. His books “Security Analysis” (1934) and “The Intelligent Investor” (1949) remain essential reading for value investors. The book Security Analysis was co-written with David Dodd, who was a protégé and colleague of Graham at Columbia Business School.

In his investment philosophy, Graham stressed careful security analysis, emotional detachment, and independent thinking. He also emphasized the importance of being able to distinguish the price of a stock from the value of the underlying business, and he is recognized as the driving force behind Security Analyst becoming a recognized profession.

Through his books, practical work and teachings, Graham laid a lot of foundations that are still in effect today when it comes to value investing. After graduating from Colombia University, Graham worked on Wall Street and eventually established a succesful mutual fund named Graham – Newman. He was also a professor at Columbia for many years, where Warren Buffett attended his clases. Later, Graham thought at UCLA in Los Angeles as well, bringing his knowledge to the west coast. In addition to Buffett, Irving Kahn is another notable Graham-disciple, and Graham´s investment philosophy has also had a profound influence on investors such as Mario Gabelli, Sir John Templeton, Howard Marks, John Neff and Charles D. Ellis.

Warren Buffett
Perhaps the most famous value investor, Warren Buffett has consistently applied value investing principles throughout his career, building Berkshire Hathaway into a multi-billion-dollar conglomerate. Buffett emphasizes buying high-quality businesses at reasonable prices and holding them for the long term. Due to his long-term business and investment success, he is often referred to as the “Sage of Omaha” (his birthplace).

He has been the chairman and largest shareholder of Berkshire Hathaway since 1970, turning it into one of the United States´ most notable holding companies. He is one of the richest and most well-known value investors in the world, and as of June 2024, his net worth amounted to $135 billion. Like many other well-known billionairs, he has pledged to give away most of his fortune to philanthropic causes. Together with Bill Gates, he co-founded the Giving Pledge in 2010, and he has pledged to give away 99% of his fortune.

Charles “Charlie” Munger
Warren Buffett’s business partner Charlie Munger (1924-2023) was known for his deep understanding of human behavior and its impact on investing. He complements value investing principles with insights into mental models and long-term thinking.

Just like Buffet, Munger was born in Omaha, and the two would meet over lunch at the Omaha Club, talking at length about investments.

Eventually, Munger became vice chairman of Berkshire Hathaway, serving as Buffett´s closest partner and right-hand man. Buffett credited Munger for being the “architecht of modern Berkshire Hathaway’s business philosophy”. Munger also had many successful endevours outside of Berkshire Hathaway, such as being chairman of Wesco Financial in 1984-2011, being chairman of the Daily Journal Corporation, and being a director of the Costco Wholesale Corporation.

Munger credited part of his success in business and investing to playing a lot of cards in college and during his time in the Army.

“What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.” – Charlie Munger

Munger advocated against treating company shares as baseball cards, since doing this forces you to predict the behaviour of humans – who are often irrational and emotional.

Munger coined the term Lollapalooza effect, denoting how a combination of multiple biases, tendencies, and mental models can act in compound with each other at the same time, in the same direction. The result of this can be extreme and will increase the likelihood of a person making irrational decisions.