Many of the greatest investors (Benjamin Graham, Warren Buffett, and Seth Klarman) that have ever lived have employed some form of value investing as an integral part of their overall stock investing strategy. However, value investing is a broad term applied to many strategies under its umbrella. While no investment strategy can guarantee positive returns, there are some lessons to take away from the value investment strategy that can possibly help reduce downside risk.
Despite there being many different ways to incorporate a value investment strategy into your own investing approach, there is common ground that carries from value investor to value investor. The most basic definition of value investing is to look for investment opportunities in companies that they believe are trading in the market below its intrinsic value. To put it simply, buy when the market price is below what they believe the fundamental value of the company is. Additionally, most value investing strategies attempt to exploit disconnects that occasionally occur between a company’s stock price and its true underlying fundamental value. This means that value investors believe that the market makes mistakes but eventually corrects them over time, a thought process about market that goes against the Efficient Market Hypothesis. As Warren Buffett once said in a talk he gave at Columbia Business School in 1984, “The common intellectual them of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on a Monday or Thursday, or whether it is January or July, etc”. In addition, value investors are generally risk-averse, meaning that while a lot of investors use volatility as a measure of risk, a value investor will look at the chance of permanent loss of capital as risk and volatility as opportunity. That in mind, a value investor will look for long term opportunities that they believe offer them a “margin of safety”.
Although value investing implies investing in a business below its fundamental value, that calculation can vary between different common stocks depending on which industry or stage of the business life cycle it is in. For example, a high dividend paying company with low growth in the utilities sector will require a much different calculation of fair value than a high earnings growth no dividend paying company in the technology sector. This paper will not delve into the different ways fair value is calculated, instead it will focus on the common ground shared by all value investors no matter which stock they are choosing to value.
Successful Value Investors Invest with a Long Time Horizon
One common thread among value investors is investing with a long time horizon and the belief that while there are short term market inefficiencies, in the long run the market will correct itself despite short-term volatility. This can be especially challenging when in the short-term the stock is experiencing extreme volatility and negative news is coming out about the company seemingly every day. It is actually this volatility and bad news which can create even more buying opportunities. It makes sense that unpopular or overlooked stocks would be more likely to be undervalued, as this unpopularity creates the discrepancy between fundamental value and price. The greatest opportunities in the eyes of a value investor are when a company that continues to have strong fundamentals and good leadership experiences a drop in stock price.
While it is challenging to not give into temptation and participate in the crowd mentality, it is sticking to your guns that can prevent unnecessary loss of capital. In addition, “constantly turning over your portfolio is expensive as you are exposed to transaction costs, making you losses bigger and your gains smaller… But more importantly, accomplished value investors also understand that in the long run, fundamentals matter most.”
Value Investors Care Deeply about Capital Appreciation and Total Return
It is true that value investors tend to not care about short-term price fluctuation or losses and are more focused on not losing capital. It is also true that value investors care deeply about realizing profits. A true value investor will be willing to accept losses in the short-term because they know that in the long-term stock performance is linked to the underlying success of the business, not speculation about its future.
In this light, a value investor will pay less attention to media reports and instead look at the underlying fundamentals such as dividends (if one is paid), free cash flow, debt level, and earnings growth to name a few. If the company has exhibited a history of strong performance under great leadership, a short term dip could be looked at as a signal to buy more instead of sell.
Value investors do care about more than avoiding loss of capital; they just usually have the patience and conviction in their research to wait for the value to be realized. This, by no means, suggests that they are right 100% of the time, but it does indicate that they believe if they have done the proper and thorough research and have used a margin of safety, they have a good chance at realizing significant total return on their investments.
Value Investors Invest with a Margin of Safety
Not only do value investors tend to look for stocks that they believe are trading below their intrinsic value, but they want to find stocks that are trading well below their intrinsic value. This concept is called margin of safety. The main risk that most value investors is the chance at permanent loss of capital. This in mind, they believe the larger the difference between price and intrinsic value; the less likely it is that they will lose money.
The idea of margin of safety is especially important since it is impossible to include every factor that has and is affecting the company. Also, because the future is impossible to predict, it makes sense that investors are unable to calculate a company’s intrinsic value with absolute certainty. Value investors who know and understand their limitations will be certain to invest in companies only when they believe a large margin of safety exists. In addition, the companies that have the largest margin of safety will have the largest return if their value is fully realized by the market. So it can be viewed as both a protection against your own biases as well as a way to be more efficient with investments and possibly receive larger returns.
Value Investors are often Contrarian Investors
The most value in the market often comes from going against the overall sentiment in the market. This makes sense as the market price and intrinsic value would be constantly matched up if everyone was valuing it the same way. This thinking goes against the Efficient Market Hypothesis (EMH) which states that the market instantaneously incorporates and reacts to any new developments about the company.
Instead value investors try to find pockets of inefficiencies and look to capitalize on those inefficiencies before the market corrects itself. This requires a lot of confidence and the ability to remain rational every time a new piece of news-good or bad- comes out about your holdings.
Warren Buffett says that the two most powerful emotions in investing are fear and greed. Understanding this, value investors sell to those who are greedy and willing to overpay while buying from those who are fearful and willing to sell at a bargain. A perfect example of this is during the financial crisis in 20082009 when the market crashed and many financial companies were selling at pennies to the dollar. Many investors wouldn’t touch them. For example, in February 2009 Wells Fargo & Company (WFC) was trading at the low price of $12.10. Many investors missed out on this opportunity as they were fearful to get involved in what was a distressed industry at the time and, as a result, missed out on an over 350% price increase to $54.79 (February 2015) in just six years time.
Why doesn’t everyone invest with a Value Approach?
With big names in investing like Warrant Buffett, Charlie Munger and Benjamin Graham experiencing such great success with this style of investing, one would think the strategy would become oversaturated and obsolete. The reason there are still opportunities with this strategy is that most people do not want to put in the hard work it takes to uncover these undervalued stocks. Another reason is that a lot of the best opportunities are with companies that are unattractive and out of favor and most people do not have the patience to sit through multiple periods of underperformance before the value is actually realized and instead get caught chasing returns. That is why there is still value in value investing for the hardworking investor who is able to stay level-headed and rational even in the toughest of times.