By Parikshit Mistry, Carnegie Mellon University
What is value investing?
Value investing involves selecting companies whose stocks trade at less than their intrinsic values, and thus, are undervalued in the market. Most value investors seek stocks with low price-to-earnings and/or high dividend yields, and then analyze the fundamentals of firms, before picking specific stocks. Since these investors hold on to their stocks until they feel that their prices correspond to their intrinsic values, this style of investment is usually long-term.
The history of value investing
Many investors consider Ben Graham to be the father of value investing. A financial analyst and professor at Columbia University, Graham, along with David Dodd, co-authored a book called “Security Analysis”, in which he laid out certain criteria for finding undervalued stocks. These criteria involve comparison of various features of each stock with benchmarks in the market (for instance, AAA corporate bond yields) and other financial indicators of the company (such as current assets and debt). Ever since these stock “screens” were penned for the first time, numerous other criteria have developed, but many of them are derived from the original ideas put down by Graham. Also, several studies have found that in the long-term, investments made under Graham’s criteria have significantly outperformed the market.
Main features of value investing
Although the term “value investing” is itself quite subjective, there are three major approaches that are related to this term. One involves using fixed criteria to screen undervalued stocks and holding them for the long-term. Another approach involves buying a stock after a “sell-off”, which is usually a period of time when the stock is down, and the third strategy entails purchase of a large stake in a company that is fundamentally undervalued, and then pushing for change that will improve its performance over time. While specific methods of investment can vary among investors, there are certain factors that one can keep in mind while undertaking this style of investment:
- Invest in firms with low price to book value ratios Ever since the 1960s, studies have shown that firms with price to book value ratios significantly outperformed those with higher ratios. This is because in the long-run, stock prices move in a way that represents the intrinsic value of a firm.
- Have long investment horizons Stocks often require some time to realize their intrinsic values. Also, while there may be certain occurrences that could result in temporary swings in stock prices, it is important to remain patient and not sell in frenzy.
- Diversify Despite undertaking thorough analyses of stocks, it is very likely that some firms may fail due to internal and/or external factors. It is best to prepare for such events by picking stocks from a variety of sectors.
Warren Buffett’s style
While most of Warren Buffett’s investment principles are similar to those laid out by Graham, his strategy puts emphasis on the following aspects:
- Sound management Buffett feels that there are a number of indicators that show good management, one of which is effective use of retained earnings.
- Earning capacity of the firm He looks into the way firms deal with inflation and manage capital expenditure, and also analyzes the strength of their brand names.
- Simplicity Buffett invests in companies whose lines of business are simple to understand.
Precautions for value investors
- Subjectivity in analysis Even with the same pieces of information, different investors may place different values on a company. Thus, it is imperative that value investors keep a “margin of safety”, when making investment decisions.
- Future uncertainties Several financial analyses focus too much on the present, without exploring the future in detail. By understanding the nature of the business and industry, one can understand the long-term trend of a stock, and possibly gain an idea of hurdles that it may encounter along the way.
