Value investing is a term you likely have encountered during your investing journey. Many legendary investors, such as Warren Buffett and Benjamen Grapham, are considered value investors. Indeed, many reputable investors think value investing is the only proper form of investing out there.
Yet, many others have questioned the effectiveness of this investment strategy in recent years. So, what exactly do we mean by value investing, and is it a strategy everyone should adopt in their portfolios?
An introduction to value investing
The premise is that the market isn't always efficient in pricing a company's intrinsic value. One of the pioneers of the value investing strategy was Benjamin Graham – an American teacher and investor – who wrote The Intelligent Investor back in 1949, which is considered by many to be the bible of value investing.
Benjamin Graham described how markets become inefficient when investors introduce two emotions into the share market – fear and greed. According to Graham, fearful or greedy investing disrupts the efficient nature of the market and leads to periodic mispricing of assets like shares.
A value investor seeks to exploit these inefficiencies to profit from them, usually by being contrarian and going against the herd (all typical value investing terms). It's the strategy most associated with the common investing phrase 'buy low, sell high'. The value investor seeks out value stocks trading below their book value.
The key to identifying a value share is that it has an inexpensive valuation compared to the value of its assets or key financial metrics, such as revenue, earnings or cash flow.
Value investors use the same logic in reverse to determine whether or not to sell a stock. Shares can go above their intrinsic valuation, sometimes even causing bubbles. That's the value investor's favourite time to sell.
Warren Buffett is regarded as one of, if not the most, eminent of value investors. According to Buffett, "If you buy things for far below what they're worth and you buy a group of them, you basically don't lose money."
That's the essence of how a value investor thinks and invests.
How you can use value investing
Because value investors look for mispricing opportunities in the share market, they must first assume a company's share price doesn't automatically equate to its intrinsic value.
It's up to the investor to form their own judgement of what a company is worth. There are different methods of performing this valuation, but some standard models are the discounted cash flow and the cap rate methods.
A discounted cash flow model uses a projection for how much cash flow a business will produce in the future to determine a future value for the company. That future value is then discounted to decide what the company is worth today.
Analysts and investors typically use the cap rate (or capitalisation rate) method for real estate and ASX stocks. It measures how much net income a house or a company is likely to produce against its current market price.
Value investors will also use metrics such as the price-to-earnings (P/E) ratio, price-to-book ratio, or price-to-free-cash-flow ratio. A low PE ratio or PB ratio can indicate an undervalued stock.
If, after performing their security analysis, the investor concludes a company is indeed worth more than what the stock market currently assumes, you have the beginnings of a value investment.
The best value shares have other attractive characteristics that appeal to value investors. These include:
- A well-established business with a long history of success
- Consistent profitability
- Stable revenue streams
- Steady dividend payments, although paying a dividend is not required to qualify as a value share.
The margin of safety
Many value investors also like to employ a margin of safety. The more significant the difference between intrinsic value and current share price, the greater the margin of safety for value investors. Not every value stock will see its share price increase, so a margin of safety helps value investors minimise losses when they're wrong about a company.
Utilising a safety margin involves only buying a company's shares if the buy price exceeds a margin to account for valuation errors the investor might have made or unforeseen complications to their investment thesis. Every value investor's margin will differ, but typical margins are 20%, 30%, or even 50%.
So, if a company's buying price or fair value is $100 a share, and the value investor uses a 50% margin of safety, they will only consider buying if the share price hits $50.
Utilising a margin of safety is no guarantee that the share price won't fall further, but it makes additional share price declines less probable and dramatic. A good value share can reduce the chance of losing money and provide the potential to cash in once the market recognises the share's actual value.
An example of a value investing model
Let's use a common ASX share as an example – Woolworths Group Ltd (ASX: WOW). We'll assume the Woolworths stock price is $40. That tells us that the financial market is assigning a value of $40 a share to Woolworths.
A value investor might look at Woolies and (hypothetically) determine the company's actual value from their calculations is $60 a share. So, the investor has identified potential mispricing. But say that investor also wants to employ a 50% margin of safety, just to be sure they won't lose money, per Buffett's advice.
Thus, this investor will only consider buying into Woolworths at $30 per share. If the price falls to $30, that investor will buy Woolies shares with the assumption that, over time, the share market will revalue Woolworths at its 'true' value of $60 a share, making the value investor a handy profit in the process.
However, value investing can require patience because it often takes a long time for a value share to get repriced at a more appropriate and higher level. But for those willing to wait, the returns can be pretty sizeable.
The problems with value investing
This all sounds great – after all, you can't go wrong with Buffett, right?
Well, value investing has its detractors, too. Critics often point out that investing in a growth stock (especially a small one) is challenging using the value investing methodology. Metrics like the P/E ratio and free cash flow don't work well for growth investing.
Additionally, when we're trading in a bull market, the earnings multiples of most shares are lifted. As such, it can be increasingly difficult to find undervalued shares during these times, let alone those offering a margin of safety.
Value investors typically love a market crash or correction (when fear dominates) because share prices tend to devalue across the board. But until 2020, the ASX hadn't seen a significant market crash for more than a decade. That's a long time to wait for shares to become undervalued. More recently, the ASX market officially went into correction territory in late October 2023, offering potential value investors a fresh bite of the cherry.
But in less volatile times, value investors can go for long periods without finding many lucrative investment opportunities – not ideal for any investor.
Even Warren Buffett's strategy has evolved from buying undervalued assets to identifying high-quality businesses at reasonable values. As Buffett explains, "Better to buy a wonderful business at a fair price than a fair business at a wonderful price."
Avoiding value traps
A value trap is a share that looks cheap but isn't. Situations to watch out for that can result in value traps include:
- Companies in cyclical industries like manufacturing and construction often see their earnings rise substantially during boom times, then fall when conditions cool off. When the market sees a possible bust ahead, share valuations can look inexpensive compared to earnings made during the boom.
- Companies that rely on intellectual property are prone to becoming value traps. For example, if a biotech company has a high-selling drug treatment but is soon to lose its patent protection, much of its profits can disappear quickly. The same is true of a tech company that is the first mover in a new industry but cannot protect itself against the competition.
To avoid value traps, remember: when valuing an ASX share, the future is more important than the past. If you focus on a company's sales and earnings growth prospects in the months and years to come, you're more likely to find good value shares.
Foolish takeaway
Value investing is one of the most successful strategies for investing in the share market and is used by some of the world's best investors, including Warren Buffett and Ben Graham. However, it's not without its pitfalls.
As such, many investors choose to use value investing principles in combination with other strategies to compensate for this. At the end of the day, it's just one of many strategies you can try to see if it fits your investing temperament.
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