What Is Value Investing?

What Is Value Investing?

Value investing involves picking stocks that seem to be trading for less than their book value. As a value investor, I believe the market overreacts to good and bad news, causing stock prices to move in ways that don't match a company's long-term fundamentals. This overreaction creates opportunities for you to profit by buying stocks at discounted prices.

You probably know Warren Buffett as the most famous value investor today, but there are others like Benjamin Graham, who was Buffett's professor and mentor, David Dodd, Charlie Munger as Buffett's business partner, Christopher Browne another Graham student, and billionaire hedge-fund manager Seth Klarman.

Key Takeaways

Value investors like me actively seek out stocks we think the market is underestimating. We rely on financial analysis, avoid following the crowd, and commit to long-term holdings in quality companies. This approach stems from a concept developed by Columbia Business School professors Benjamin Graham and David Dodd in 1934. Research consistently shows that value stocks outperform growth stocks and the overall market in the long run.

How Value Investing Works

The core idea of value investing is simple: if you know the true value of something, you can save money by buying it on sale. Think about it like purchasing a TV—whether it's on discount or full price, you get the same product. Stocks operate similarly; a company's share price can fluctuate even if its underlying value stays constant. Strictly speaking, there's no absolute intrinsic value for a stock, but relative values exist.

Market participants trade shares without a fixed objective price, leading to price swings from demand changes. If fundamentals and future prospects remain the same, the shares' value doesn't change, even if the price does. Value investing originated from Graham and Dodd's 1934 concept and gained fame through Graham's 1949 book, 'The Intelligent Investor.'

Just as smart shoppers avoid full price for TVs that go on sale, value investors see stocks the same way. Stocks don't have predictable sale times like Black Friday, and discounts aren't advertised. You have to do the detective work to find these hidden deals, buying at a discount to market value and holding long-term for handsome rewards.

Intrinsic Value and Value Investing

In the stock market, a cheap or discounted stock means its shares are undervalued. As a value investor, you aim to profit from these deeply discounted shares. You use metrics to find a stock's intrinsic value, combining financial analysis of performance, revenue, earnings, cash flow, and profit with factors like brand, business model, target market, and competitive advantage.

Common metrics include price-to-book (P/B) which compares asset value to stock price—if lower, it's undervalued assuming no financial distress; price-to-earnings (P/E) which checks if the price reflects earnings; and free cash flow, the cash left after expenses for investments, debt, dividends, or buybacks. Other metrics involve debt, equity, sales, and growth. If the stock's price versus intrinsic worth looks attractive, you decide to buy.

Margin of Safety

You need room for error in value estimates, so set a personal margin of safety based on your risk tolerance. This principle, key to value investing, means buying at bargain prices for better profit chances and lower loss risk. If you think a stock is worth $100 and buy at $66, you profit $34 when it hits true value, plus potential growth. At $110, that's $44 profit versus just $10 if bought at full price. Benjamin Graham suggested buying at two-thirds or less of liquidation value for best returns and minimal downside.

Value Investors Believe the Markets Aren't Efficient

We value investors reject the efficient-market hypothesis that prices always reflect all information. Instead, we see stocks over or underpriced for reasons like poor economy causing panic sales, as in the Great Recession, or excitement over unproven tech like the dot-com bubble. Biases from news like earnings surprises, recalls, or litigation can distort prices. Undervalued stocks might also be overlooked by analysts and media.

Value Investors Don't Follow the Herd

We're contrarians—when others buy, we sell or wait; when they sell, we buy or hold. We skip trendy, overpriced stocks and focus on solid financials in lesser-known companies or fallen household names that can recover. You should view a stock as ownership in a company with sound principles, ignoring outside noise.

Value Investing Requires Diligence and Patience

Estimating intrinsic value mixes financial analysis with subjectivity—it's part art, part science. Different investors might reach different conclusions from the same data, so develop your strategy. Some focus on current financials, others on growth and cash flows; Buffett and Lynch combine both to spot mispriced stocks. The logic is to buy assets below worth, hold long-term, and profit on return to value. It won't bring quick wins—expect years of waiting and occasional losses, but long-term gains are taxed lower.

Stick with your philosophy patiently. Buy sound fundamentals even if overpriced now, or wait for better prices. If nothing fits, let cash sit until opportunities appear.

Why Stocks Become Undervalued

Rejecting efficient markets, you can spot undervaluation causes. Market moves and herd mentality lead to irrational buys on rises or sells on falls due to fear of missing out or loss aversion, exaggerating movements. Bubbles from exuberance burst into crashes, like dot-com or housing in 2006-2008. Unnoticed stocks, like small caps or foreign ones, get ignored while glamour tech draws crowds. Bad news like litigation hits good companies temporarily, but value investors see beyond for long-term worth. Cyclical fluctuations from economy or seasons affect profits but not intrinsic value.

Value Investing Strategies

Thoroughly research companies and make sensible choices. Ask if revenue can grow by raising prices, boosting sales, cutting expenses, or shedding unprofitable parts. Study competitors for growth prospects—these are speculative without hard data, so it's a guessing game. Buffett advises investing in familiar industries. Choose stocks of enduring companies with high-demand products. Watch insider buying—managers or 10% owners buying signals confidence; mass selling warrants scrutiny. Analyze financial reports like 10-K and 10-Q for performance, including balance sheet (assets vs. liabilities), income statement (revenue, expenses, profits), and cash flows (inflows/outflows).

Couch Potato Value Investing

You can value invest passively without reading reports by holding mutual funds or ETFs that follow value strategies or track investors like Buffett. Buy Berkshire Hathaway shares for exposure to his evaluated companies.

Risks With Value Investing

Losses can happen despite low-to-medium risk. Ensure accurate, updated financial analysis—study footnotes for details. Exclude extraordinary items like lawsuits for true performance, but watch patterns signaling issues. Ratio flaws arise from tax differences, estimations, or accounting variations, complicating comparisons. Overpaying risks capital, so build margin of safety by buying below two-thirds of value. Diversify across 10-30 stocks in different sectors, though some say fewer if chosen well. Avoid emotional decisions—don't panic sell on drops. Example: Fitbit's 2016 drop post-earnings was overreaction; value investors saw undervaluation, profiting later on Google's buyout.

The Bottom Line

Value investing is long-term—Buffett holds assuming markets could close for years. Sell when prices exceed fair value for major needs, holding diverse stocks for outlook.