What is Value Investing?

What exactly do we mean by value investing, and is it a strategy that everyone should adopt in their portfolios?

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Value investing is a term you might have come across in the course of your investing career. Many legendary investors like Warren Buffett are classed as ‘value investors’. 

Indeed, many investors think value investing is the only true form of investing out there. Yet it has also been called into question in recent years. 

So, what exactly do we mean by value investing, and is it a strategy that everyone should adopt in their portfolios?

An introduction to value investing

The premise of value investing is built on the concept that the market isn’t always efficient in pricing a company’s true intrinsic value. One of the pioneers of the value investing strategy was Benjamin Graham – an American teacher and investor – who wrote The Intelligent Investor back in 1949, which is considered by many to be the ‘bible’ of value investing. 

Graham described how markets become inefficient when investors introduce 2 emotions into the sharemarket – fear and greed. According to Graham, fearful or greedy investing disrupts the efficient nature of the market and leads to periodic mispricing of assets like shares. 

A value investor seeks to exploit these ‘inefficiencies’ in order to profit from them, usually by being ‘contrarian’ and ‘going against the herd’ (all common value investing terms). It’s the strategy most associated with the common investing phrase ‘buy low, sell high’.

Value investors can also use the same logic in reverse to determine whether a share should be sold. Shares can go above their intrinsic valuation as well as below, sometimes even causing bubbles. That’s the value investor’s favourite time to sell.

Buffett’s golden rule

As mentioned above, the famous investor Warren Buffett is regarded as one of, if not the, most eminent value investors. You may have heard Warren Buffett’s 2 rules of investing, which go something like this: “The first rule of investing is don’t lose money, and the second rule is don’t forget the first rule.” 

Buffett justified these rules by adding: “If you buy things for far below what they’re worth and you buy a group of them, you basically don’t lose money.” 

That’s the essence of how a value investor thinks and invests.

How you can use value investing

Because a value investor looks for mispricing opportunities in the share market, the first thing a value investor must do is assume a company’s share price doesn’t automatically equate to its true value. 

It’s then up to the investor to form their own judgement of what a company is worth. Investors have different methods of performing this valuation, but some common models are a discounted cash flow, and the cap rate method. 

A discounted cash flow model uses a projection for how much cash flow a business will produce in the future and determines a future value for the company. That future value is then ‘discounted’ back to come up with a buying price today.

The cap rate method (or capitalisation rate) is a valuation method commonly used for real estate, but also for stocks. It measures how much net income a house or a company is likely to produce against its current market price. 

A value investor will also commonly use metrics such as the price-to-earnings (P/E) ratio, price-to-book ratio or price-to-free cash flow ratio to help in this determination.

If, after performing their own valuation, the investor concludes a company is indeed worth more than what the market assumes, you have the beginnings of a ‘value investment’.

Margin of safety

Many value investors also like to employ a concept known as the ‘margin of safety’. A margin of safety is an added safety net for a value investor that ensures they are only buying an asset that’s truly undervalued.

This involves only buying a company’s shares if those shares meet the value investor’s buy price for the company as well as exceeding a ‘margin of safety’ to account for any errors the investor might have made or unforeseen complications to their investment thesis. Every value investor’s margin will be different, but common margins are 20%, 30% or even 50%. 

So if a buying price or intrinsic value of a company is determined to be at $100 a share and the value investor uses a 50% margin of safety, they will only consider a buy if the share price hits $50.

An example of a value investing model

Let’s use a common ASX share as an example – Woolworths Group Ltd (ASX: WOW). We’ll assume Woolworths shares are trading for $40. That tells us that the market is assigning a value of $40 a share to Woolworths. 

A value investor might look into Woolies and (hypothetically) determine that Woolworths’ true value from their calculations is $60 a share. So the investor has identified a potential mispricing. But say that investor also wants to employ a 50% margin of safety –  just be absolutely sure they won’t ‘lose money’, as Buffett puts it.  

Thus, this investor will only consider buying into Woolworths at $30 per share. If the price falls to $30, that investor will buy Woolies shares with the assumption that, over time, the share market will revalue Woolworths at its ‘true’ value of $60 a share, making the value investor a handy profit in the process.

The problems with value investing

I’m sure this all sounds great – after all, you can’t go wrong with Buffett, right? 

Well, value investing has its share of detractors too. Critics will often point out that it’s very difficult to invest in a ‘growth share’ (especially a small one) using value investing methodology. Metrics like the P/E ratio and free cash flow don’t work very well for these kinds of companies, and so many value investors will avoid them. 

Additionally, when markets are in a bull market, it usually lifts the earnings multiples of most shares on the market. As such, it can be increasingly difficult to find ‘undervalued’ shares during these times, let alone those that offer a margin of safety as well. 

Value investors typically love a market crash (when fear dominates) because share prices tend to get dramatically devalued across the board. But until 2020, the ASX hadn’t really seen a significant market crash for over a decade. That’s a long time to wait for shares to become undervalued. 

Thus, value investors can go for long periods of time without finding too many lucrative investment opportunities – not an ideal situation for any investor to be in.

The bottom line

Value investing is one of the most successful strategies for investing in the share market and is used by some of the best investors in the world. However, it’s not without its pitfalls. 

As such, many investors choose to use value investing principles in combination with other strategies to compensate for this. At the end of the day, it’s just one of many strategies you can try out and see if it fits with your own investing temperament.

 

Guide last updated 19 August, 2021
Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.