What is Value Investing?

In the words of Seth Klarman, value investing…

“is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.”

Value investors look to capitalise on market misperceptions by buying companies with (cheap) valuation metrics (such as low P/B) that are not justified by long-term fundamentals. In which circumstances do securities sell at a considerable discount to intrinsic value? This tends to happen for a number of reasons, including recent earnings disappointments, businesses in out of favour industries, businesses with small market capitalizations (which get less attention from investors), and various psychological errors of judgment that investors commonly make which drive down market values. John Templeton puts this in very practical terms when stating:

“People are always asking me where the outlook is good, but that is the wrong question. The right question is: Where is the outlook most miserable….There is only one reason a stock is being offered at a bargain price: because other people are selling. There is no other reason. To get a bargain price, you have to look where the public is most frightened and pessimistic.”

Investors are rarely entirely dispassionate in their analysis and often act irrationally, basing investment decisions on emotions and perception rather than reality. Value investors seek to exploit this fact. History is replete with examples of asset mispricings reaching extreme levels, such as the 2007-8 subprime mortgage crisis, the 1989 Japanese Nikkei bubble, the late 1990s dot.com bubble, and many more. More commonly however, mispricings exist on a more modest scale in almost all markets. For long-term oriented investors, these market inefficiencies create opportunities to buy undervalued assets or sell short overvalued ones. While this may sound intuitive and commonsensical to many, it is more easily said than done.

A central principle in a “value” oriented investment approach is that of independent thought and a willingness to take positions that are often at odds with market consensus. As John Maynard Keynes put it: “My central principle of investment is to go contrary to general opinion, on the ground that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.” John Templeton echoes this reality when stating that

“If you want to have a better performance than the crowd, you must do things differently from the crowd.”

 

Further Reading: (also see Recommended Reading)

What Has Worked In Investing: Studies of Investment Approaches and Characteristics Associated With Exceptional Returns – Tweedy, Browne

Value Investing Retrospective – Columbia Business School – Andrew Dubinsky

The Seven Immutable Laws of Investing – James Montier

The Superinvestors of Graham-and-Doddsville – Warren Buffett

Does Value Investing Work? – ValueWalk