Value Investing and Value Stocks Explained
By Terence Martin
The value investor adheres to the principle of buying only undervalued stocks - undervalued in the sense that the stock's current price fails to reflect (as far as the investor is concerned) its 'fair' market price or its true 'intrinsic worth'. Famous advocates of the value investing philosophy include the legendary and very much alive investor Warren Buffet, and the late Benjamin Graham - one of the first proponents of value investing, a subject he taught as a professor at the Columbia Business School in 1928.
The overriding reason why value investors seek out undervalued stocks is because value stocks tend to offer a higher degree of capital preservation than growth stocks. Value investors are not so much concerned with how much they might make out of an investment, but how much of their capital they could lose - i.e. having bought a stock, what are the chances of the price falling never mind rising?
What's a stock worth?
Depending on when and where you look - and even if the business appears to be totally sound and is making money - it's not particularly difficult to find stocks where, for one reason or another, the stock price fails to reflect the intrinsic worth of the business. But how can a value investor establish a company's true intrinsic worth? In other words, how does the value investor pinpoint an undervalued company?
It's all in the numbers
Essentially, value investors use cold, hard, quantifiable historical data to determine whether a stock is undervalued or not. The experienced value investor will analyze a range of the businesses' financial fundamentals such as the price-earnings ratio (P/E), earnings yield, discounted cash flow analysis (DCF) and price-to-book ratios - to name but four of the nine+ key fundamental ratios. The numbers that emerge from that quantitative analysis provide a reasonably accurate indication of the company's real worth and whether its shares are fairly valued or not. If a stock's fair value is higher than its current market price, then that stock might be a value stock - assuming of course that there are no obvious reasons why the price is lower than it ought to be.
Why stocks are undervalued
Assuming the stock doesn't warrant the cold shoulder from investors, stocks can be undervalued because they're not particularly popular with the investors at that moment of time, or simply because the stock is off the market's radar. Even if the fundamentals add up, a stock can deserve to be undervalued because of disappointing results, a poor credit rating, management changes, a scandal of some kind, the business is unfashionable, or there are problems relating to the company's products or services. Where those circumstances exist, and the stock price is lower than the fundamentals suggest it ought to be, that stock is sometimes deemed to be a 'Value Trap'.
Comparing apples with apples
It is also possible for two investors to analyze the same fundamentals and each come to a different conclusion regarding the intrinsic value. If however each investor calculated the values applying Benjamin Graham's principles - where the focus is totally on documented historical numbers - both individuals would reach the same number.
About the Margin of Safety
By purchasing a stock which is priced at less than its real worth, the chances of the price falling much further are relatively low and as such the investor's capital is less exposed to risk. For that reason, value stocks are considered to offer a 'Margin of Safety' - the higher the MoS, the better protected the investors capital is judged to be. As mentioned previously, it can be extremely difficult to calculate accurately a stock's intrinsic worth, so a reasonable Margin of Safety (MoS) can shield the investor from the adverse effects of incorrect calculations, a market downturn, or both. For large cap, blue chip and highly liquid stocks, and having established the stock's intrinsic value, the value investor would hope to purchase that stock at a 90% discount to its intrinsic value - i.e. a 10% MoS: more speculative, smaller or illiquid stocks should ideally be bought at a discount of 50%+ to their intrinsic value, thus providing a 50% MoS.
The attractions of value investing
� The MoS can provide an element of capital preservation
� Value investing is a single minded and highly disciplined approach: Value investors make their investment decisions based on cold, hard facts, rather than hype, fashion, trends or human emotions
� The returns: In 1984, having examined the performance of investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham, Warren Buffett concluded that as a doctrine, value investing is, on average, successful in the long run
The disadvantages of value investing
� Value investors must be prepared to miss out on short term investment opportunities
� Value investing requires willpower. Value investors buy when other people are selling and sell when other people are buying, which can pose psychologically difficulties for some investors
� Value investing demands patience - essentially it's a 'buy and hold' strategy
� The 'value trap': a stock may be undervalued not just because it's out of favour with the market but because it deserves to be
� The importance or relevance of more qualitative analytical factors such as the abilities of a company's management or the value of its brands or goodwill are not taken into account