Value Investing

Share prices don’t exist in a vacuum. Instead, they represent what it costs, at one point in time, to buy a tiny proportion of a company listed on the stock exchange – a company that employs people, produces goods or services and, hopefully, generates revenue, profit and cash flow.

Alongside this quoted stock price, value investors also take account of a company’s underlying, or ‘intrinsic’, value. Unlike the stock price, you can never get an exact fix on this figure but you can sometimes make a reasonable estimate by undertaking ‘fundamental analysis’, which involves looking at a company’s financial statements over time and making an assessment of its management, markets and growth potential.

Share prices, you may have noticed, vary enormously over the course of a year. But a business’s revenue, profit and cash flow rarely change anything like as much as its share price. The reason for this is that the price of a company’s shares is only a reflection of what people are willing to pay for them at any given time. Sometimes, usually when prices are rising, they’re greedy. When prices fall, they become fearful and rush for the exits. All this emotion can push the share price a long way from the intrinsic value of the underlying business.

We aim to benefit from this by buying shares when they’re trading at significantly less than their intrinsic value. Or, to put it another way, buying a dollar’s worth of value for 50 cents.

Value investing didn’t develop overnight. It was the quest of one man in particular and another who followed him.

The founder of the modern ‘school’ of value investing was Benjamin Graham, considered ‘the father of modern security analysis’. Along with David Dodd, Graham co-authored Security Analysis, and later, a less highbrow, book on fundamental analysis called The Intelligent Investor (where we got our name). Despite his academic brilliance, Ben Graham’s practical application of value investing was simplicity itself. His investment partnership bought stocks that were trading at a significant discount to their liquidation value, which he calculated – conservatively – from the balance sheet. But, as one of Graham’s students soon discovered, the numbers didn’t always tell the whole story.

Warren Buffett studied under Graham at Columbia University and embraced value investing with gusto. But he became less interested in Graham’s numbers-based approach. He wanted to know what really made one business better than another. Buffett soon realised it came down to those businesses with a strong ‘franchise’ and excellent management. He worked out that businesses with strong market positions, excellent brand names, good cost control, high free cash flow and honest and capable management usually performed better over the long term.

Graham would buy any business if it was cheap enough; Buffett prefers to buy only quality businesses with excellent management. And while Graham stressed diversification, to reduce the impact of the occasional but inevitable losses from buying poor businesses, Buffett’s focus on quality has enabled him to concentrate his portfolio. Finally, Graham would sell a stock if it no longer met his strict numerical criteria, while Buffett has said that for his carefully selected business franchises, his ‘favourite holding period is forever’.

Despite their different approaches, both Graham and Buffett have always assessed their investments in a business-like fashion and have always made sure of a considerable margin of safety in their purchases.

If value investing works so well, why doesn’t everyone jump on the bandwagon?

Not everyone is able to view movements in stock prices with the detachment that’s required of a value investor; if they could, then the sharemarket extremes caused by fear and greed would not occur.

This paradox is one of the keys to the success of the value approach: the concepts are extremely simple to grasp but can be very difficult to put into action. Why? Human psychology. Most stocks tend to be priced about right much of the time. Something significant usually has to happen for a stock to become under or overpriced; a profit warning or a competitor releasing a super-duper new product, for example. In other words, an attractive opportunity for value investors is very often caused by bad news, while good news is very often the signal to head for the exits.

Value investors have to be contrarian, looking for the positives when everyone else is looking at the negatives (and vice versa). Humans are hard-wired to follow the crowd, but that’s usually an unprofitable course of action in the sharemarket.