Value investing is an
investment paradigm that derives
from the ideas on investment and
speculation that Benjamin Graham &
David Dodd set forth in their 1934
book
Security Analysis.
Although value investing has taken
many forms since its inception, it
generally involves buying securities
whose shares appear underpriced by
some form(s) of fundamental
analysis.
As examples, such securities may be
stock in public companies that trade
at discounts to book value or
tangible book value, have high
dividend yields, have low
price-to-earning multiples or have
low price-to-book ratios.
Notable proponents of value
investing, including Berkshire
Hathaway chairman Warren Buffett,
have argued that the essence of
value investing is buying stocks at
less than their intrinsic value. The
discount of the market price to the
intrinsic value is what Benjamin
Graham called the "margin of
safety". The intrinsic value is the
discounted value of all future
distributions.
However, the future
distributions and the appropriate
discount rate can only be predicted.
Warren Buffett has taken the value
investing concept even further as
his thinking has evolved to where
for the last 25 years or so his
focus has been on "finding an
outstanding company at a sensible
price" rather than generic companies
at a bargain price. This concept is
important as you are actually buying
into a business.
Value investing was established by
Benjamin Graham and David Dodd, both
professors at Columbia University
and teachers of many famous
investors. In Graham's book The
Intelligent Investor, he advocated
the important concept of margin of
safety — first introduced in
Security Analysis, a 1934 book he
co-authored with David Dodd — which
calls for a cautious approach to
investing.
In
terms of picking stocks, he
recommended defensive investment in
stocks trading below their tangible
book value as a safeguard to adverse
future developments often
encountered in the stock market.
Book Value
However, the concept
of value (as well as "book value")
has evolved significantly since the
1970s. Book value is most useful in
industries where most assets are
tangible. Intangible assets such as
patents, software, brands, or
goodwill are difficult to quantify,
and may not survive the break-up of
a company. When an industry is going
through fast technological
advancements, the value of its
assets is not easily estimated.
Discounted Cash Flow
Sometimes, the production power of
an asset can be significantly
reduced due to competitive
disruptive innovation and therefore
its value can suffer permanent
impairment. One good example of
decreasing asset value is a personal
computer. An example of where book
value does not mean much is the
service and retail sectors. One
modern model of calculating value is
the discounted cash flow model (DCF).
The value of an asset is the sum of
its future cash flows, discounted
back to the present.
Value Investing
Performance
Value investing has proven to be a
successful investment strategy.
There are several ways to evaluate
its success. One way is to examine
the performance of simple value
strategies, such as buying low PE
ratio stocks, low price-to-cash-flow
ratio stocks, or low price-to-book
ratio stocks. Numerous academics
have published studies investigating
the effects of buying value stocks.
These studies have consistently
found that value stocks outperform
growth stocks and the market as a
whole.
Another way to examine the
performance of value investing
strategies is to examine the
investing performance of well-known
value investors. Simply examining
the performance of the best known
value investors would not be
instructive, because investors do
not become well known unless they
are successful. This introduces a
selection bias.
Warren Buffett A better way to investigate the
performance of a group of value
investors was suggested by Warren
Buffett, in his May 17, 1984 speech
that was published as The
Superinvestors of Graham-and-Doddsville.
In this speech, Buffett examined the
performance of those investors who
worked at Graham-Newman Corporation
and were thus most influenced by
Benjamin Graham. Buffett's
conclusion is identical to that of
the academic research on simple
value investing strategies--value
investing is, on average, successful
in the long run.
During about a 25-year period
(1965-90, published research and
articles in leading journals of the
value ilk were few. Warren Buffett
once commented, "You couldn't
advance in a finance department in
this country unless you thought that
the world was flat."
Well Known Value Investors
Benjamin Graham is regarded by many
to be the father of value investing.
Along with David Dodd, he wrote
Security Analysis, first published
in 1934.
The most lasting contribution of
this book to the field of security
analysis was to emphasize the
quantifiable aspects of security
analysis (such as the evaluations of
earnings and book value) while
minimizing the importance of more
qualitative factors such as the
quality of a company's management.
Graham later
wrote The Intelligent Investor, a
book that brought value investing to
individual investors.
Aside
from Buffett, many of Graham's other
students, such as William J. Ruane,
Irving Kahn and Charles Brandes have
gone on to become successful
investors in their own right.
Graham's most famous student,
however, was Warren Buffett, who ran
successful investing partnerships
before closing them in 1969 to focus
on running Berkshire Hathaway.
Charlie Munger joined Buffett at
Berkshire Hathaway in the 1970s and
has since worked as Vice Chairman of
the company. Buffett has credited
Munger with encouraging him to focus
on long-term sustainable growth
rather than on simply the valuation
of current cash flows or assets.
Another famous value investor is John Templeton. He first
achieved investing success by buying
shares of a number of companies in
the aftermath of the stock market
crash of 1929.
