Value investing is just one of all the available stock investment strategies. In the last 50 years, it has been shown that this strategy is a successful one, at least for those who apply it correctly. There are a lot of examples that supports this statement such as the performance of Buffett, Greenblatt, Peter Lynch or García Paramés, but let’s inquire about what is the essence of value investing.
Value investing has different schools and not all the value investors think the same about investment. The two main common ideas of this investment strategy are i) that price and value are not the same concept, and ii) that these two variables do not always coincide. Firstly, price is the amount of money needed to buy a share in the market (or the amount received in case of selling it), while value is the intrinsic worth of the share. Secondly, the market is not fully efficient, although it tends to be in the asymptote, so the price of a share fluctuates around its value.
The most important value investor, Warren Buffett, states that “price is what you pay, and value is what you get”. The inefficiency of the market, on the other hand, was brilliantly exposed by the father of Value Investing, Benjamin Graham with the allegory of Mr. Market, that states that the market is like an emotional and irrational manic-depressive person.
Based on these principles, here come the two immediate practical application regarding the investment decision: i) the price (relative to value) determines your performance, so make sure you pay less than the intrinsic value of the share. And even more, knowing that you can be wrong in your estimation of intrinsic value, make sure that the difference between price and value is sufficiently big, just in case your estimate of value is not correct. That is, buy when the margin of safety is sufficiently big. ii) Since price and value do not coincide, the market is not being efficient, and it could still inefficient a long period, although in the long run the price will recognize the value. Invest for the long run, and do not try to predict short-term market movements.
Although the common framework of all value investors is investing for the long run with a high margin of safety, there are huge differences between them. The most notable divergence among these investors is that some of them think that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, as Buffett said, which implies buying high quality business, sometimes called compounders, although the price is higher. Other investors follow the original Graham’s idea, applying what is called “deep value”, focusing on extraordinarily cheap companies, rather than in high quality ones. These investors do not care if the business has competitive advantages, if the management is good or if the growth expectations are positive; they just care about price relative to value. On a practical basis, high quality value investors focus on high return on capital companies, with good financial position, a competent management and good industry dynamics, while deep value investors focus on low price to book value and price to earnings multiples.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”
Another important concept in Value Investing, introduced by Buffett, is circle of competence, which includes all the business that one individual investor can understand. Unknown risks are the most dangerous, and thus, a good value investor never invests in a company that he does not understand. The traditional case of out-of-the circle of competence companies have been technological business, although in the last years this has changed. The circle of competence is subjective, that is, it may vary from person to person, so, for example, although most investors do not understand artificial intelligence, there may be some experts in that industry.
When talking about risk, value investors do not think that volatility as that, but rather, an opportunity. Volatility implies that stock market price decreases quickly, usually more than intrinsic value, so the margin of safety increases. In this moment, when the stock market is bearish, value investors find companies with large margins of safety. So that, an investor with a value perspective cannot think of volatility as a risk. Instead, for value investing, risk is the possibility of constant losses of wealth, that is, getting wrong on the long run.
In summary, value investing is a stock picking investment strategy in which each investment is analysed individually with a fundamental approach in a bottom-up process. Behind each investment decision, there is a high margin of safety, and, therefore, high return expectations.