The Motley Fool

The Value Investing Strategy

Boy opening treasure chest

Image source: Getty Images

Article last updated: 13 May 2020

What is value investing?

Value investing is an investment strategy that focuses on shares that are under-appreciated by investors and the market at large. The shares that value investors seek typically look cheap compared to the underlying revenue and earnings from their businesses. Investors who use the value investing strategy hope that a company’s share price will rise as more people come to appreciate the true intrinsic value of the company’s fundamental business.

The greater the difference between intrinsic value and current share price, the greater the margin of safety is for value investors. Because not every value share will turn its business around successfully, that margin of safety is important for value investors to minimise their losses when they’re wrong about a company.

What makes a great value share?

The primary defining characteristic of a value share is that it has an inexpensive valuation compared to the value of its assets or its key financial metrics, such as revenue, earnings or cash flow. However, the best value shares also have other attractive characteristics that make them appealing to value investors:

  • Well-established businesses with long histories of success
  • Consistent profitability
  • Stable revenue streams, without huge amounts of growth but typically also without big contractions in sales either
  • Dividend payments, although paying a dividend isn’t a requirement to qualify as a value share

However, it’s important to understand that a company with all of these attributes isn’t necessarily a great value share. Sometimes, a stock only appears to be a good value for investors but is actually a value trap. Value traps can continue to suffer share price declines even when their stocks seem attractive.

Why is value investing popular?

Everyone likes a bargain and because value investing looks for shares selling at a discount to their intrinsic value, the strategy appeals to those who like to get good deals. All it takes to make money with a value share is for enough investors to realise that there’s a mismatch between the share’s current price and what it’s actually worth. Once that happens, the share price should go up to reflect the higher intrinsic value. Then those who bought in at a discount will get their profit.

Furthermore, many investors like the margin of safety provided by a share that’s purchased for less than what it’s inherently worth. There’s no guarantee that the share price won’t fall further, but it does make additional share-price declines less probable and less dramatic. For those who see themselves as defensive investors without much tolerance for risk, a good value share can provide both protection against losing money and the potential to cash in once the market recognises the share’s true value.

Value investing can require patience because it often takes a long time for a value share to get repriced at a more appropriate higher level. For those willing to wait, however, the returns can be quite sizeable.

How did value investing get started?

Value investing has evolved over time. Its roots are in the Great Depression of the 1930s and its aftermath, when the strategy’s focus was purely on buying companies whose assets were worth more than their share price. That was largely because many companies were going out of business during the Depression, so opportunities to buy shares for less than the value of assets had direct implications when a company liquidated and paid out any remaining cash proceeds to shareholders.

Since then, though, value investing has grown into more fundamental analysis of a company’s cash flows and earnings. Value investors also look at a company’s competitive advantages to assess whether a share is deeply discounted.

Who are the two most famous value investors?

Benjamin Graham

Benjamin Graham is generally regarded as the father of value investing. Graham’s Security Analysis, published in 1934, and The Intelligent Investor, published in 1949, established the precepts of value investing. These include the concept of intrinsic value and the importance of establishing a margin of safety in the price you pay versus the value of the assets you buy. Graham’s strategy was often referred to as “cigar butt” investing, on the (rather disgusting) idea of picking up discarded cigar butts that still had a puff or two remaining in them.

Warren Buffett

Besides the two invaluable tomes above that Graham authored, his most lasting contribution to value investing was his role in setting the stage for legendary investor Warren Buffett to make his entrance on the value investing scene. Buffett studied under Graham at Columbia University and worked for a short time at Graham’s firm.

As the CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Buffett is perhaps the best-known value investor. Buffett cut his teeth in value investing in his early 20s. He used the strategy to deliver immense returns for investors in his partnership in the 1960s and then for Berkshire investors when he first took control of the company in the 1970s.

However, the influence of Charlie Munger, Berkshire’s vice chairman and Buffett’s investing partner for many decades, along with Buffett’s evolution as an investor, has changed Buffett’s strategy from purely buying undervalued assets to identifying high-quality businesses at reasonable values.

This famous Buffett quote best describes why his thinking on value has changed over the years:

“Better to buy a wonderful business at a fair price than a fair business at a wonderful price.”

Buffett has used his acquisition of Berkshire Hathaway, which was a struggling textile producer, as an excellent example of this thinking. He has said that buying Berkshire has likely cost investors many billions of dollars in lost returns; after all, he ended up selling off many of the company’s textile-producing assets at a loss.

Perhaps the best evidence of this is that nobody associates Berkshire Hathaway with textiles these days. Instead, mentions of Berkshire tend to bring to mind corporate subsidiaries like its GEICO insurance unit, along with the many value shares in Berkshire’s own investment portfolio.

How to find value shares

Value investing requires a lot of research. You’ll have to do your homework, going through many out-of-favour shares to measure a company’s intrinsic value and compare it to its current share price. Often, you’ll have to look at dozens of companies before you find a single one that’s a true value share.

That’s enough to intimidate many would-be value investors, but there are some tricks you can use to identify good value shares. By fully understanding the many ways to value a company and assess its business prospects, you can weed out inappropriate stocks more quickly to concentrate on your best candidates.

Avoiding value traps

A value trap is a share that looks cheap but actually isn’t. A couple of situations often produce value traps that value investors should watch out for:

  • Shares in cyclical industries like manufacturing and construction often see their earnings rise substantially during boom times, only to see much of those earnings disappear when industry conditions cool off. When investors see a possible bust coming for a share, its valuation will look very inexpensive compared to recent earnings – but much less so once earnings fall during the weaker part of the business cycle.
  • Shares in areas that emphasise intellectual property are prone to becoming value traps. For instance, if a drug company has a high-selling treatment but is losing patent protection for it in the near future, then much of its profits can disappear quickly. The same is true of a tech company that’s the first mover in a new industry but that lacks the ability to protect itself against competition.

To avoid value traps, remember: The future of a company is more important than its past when valuing a stock. If you focus on a company’s prospects for sales and earnings growth in the months and years to come, you’ll be more likely to find true value shares.

Is value investing right for you?

If your primary investing goal is to keep your risk of permanent losses to an absolute minimum while increasing your odds to generate positive returns, you’re probably a value investor at heart. By contrast, those who prefer to follow the hottest companies in the market often find value investing downright boring, as growth opportunities for value companies tend to be tepid at best.

Value investors have to be resilient as well. The value-finding process eliminates far more shares than it uncovers, and it can be a highly frustrating way to invest during a bull market. Many shares that you cross off your buy list during your search will keep rising in value in bull markets, despite the fact that you found them too expensive to begin with. But the payback comes when the bull market ends, as the margin of safety from value shares can make it much easier to ride out a downturn.

Growth vs. value investing

If value investing doesn’t match up well with your particular investing style, you might consider growth investing. Growth investing looks at the prospect of a business growing its revenue and net income dramatically over time, with an emphasis on the fastest-growing companies in the market. Growth investors don’t care nearly as much about intrinsic value as value investors do, instead counting on extraordinary business growth to justify the higher valuations that investors have to pay to buy shares.

Let value investing help you

The most important thing to understand is that value investing requires a long-term mindset. As economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” 

The lesson is that while occasionally one’s timing is lucky and an investment pays off very quickly, even a value-focused strategy doesn’t guarantee quick gains. Mr. Market doesn’t always “realise” very quickly that it was wrong about a share or that it undervalued an asset.

Value investing strategies take time to follow, but the time and effort you spend are worth it. Understanding and applying the value investing concepts that Benjamin Graham wrote about almost 90 years ago – and that Buffett and others have added to and improved upon since – will make you a better investor with better chances of being successful in choosing great shares.

Figures correct at 13 May 2020. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and recommends Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short June 2020 $205 calls on Berkshire Hathaway (B shares). The Motley Fool Australia has recommended Berkshire Hathaway (B shares). We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.