Value investing is one of the most famous investment paradigms, and one of the most successful. It is always difficult to introduce this concept to people who are yet unfamiliar with it, because it sounds too good to be true! How could there be an investment strategy/approach that is not difficult or time consuming and is consistently outperforming the market? Yet, this is what it is -an approach to investment that ticks all these boxes.
What is the main idea of value investing?
Value investing is based on the idea, that one should look for shares of companies that offer good value. How do we know that company offers a good value? We look at different metrics, such as Price to Earning ratio, or Price to Book ratio. The technical side of the process is not so important for now, as this will be covered in different articles (recipes). To explain this in simple terms- imagine value investor as your average shopper. He goes to a super market, and he sees a promotion- an item, lets say box of his favourite breakfast cereals, is at 75% discount! He takes a few packets, because he knows that he is getting value here- they are normally worth more. If he had a small shop, he could even sell them at a profit, the price was so cheap. So value investor is a guy that goes shopping and only takes the 75% off stuff. He never bothers to buy anything else. If you could do that simply, that is get all your shopping at 75% discount, you would have clearly outperformed other shoppers!
The analogy above is not perfect of course. There are some difficulties that come with buying shares of companies ‘on sale’. The first one is identifying, which ones are bargains and which ones are simply ‘rotten’. Also, even if nothing is wrong with the company, it could take long time for the market to come back to the ‘correct’ valuation. This is definitely not an investment approach for impatient, but as someone once said: ‘stock market is a device for transferring money from the impatient to the patient’. Different investors also differ slightly in their understanding which companies offer potentially good value, but there are some generally accepted ideas about it. We should look for companies with low price to earnings ratio, little debt and ideally under the ‘book value‘, but the last one depends highly on the type of the company. What is considered low price to earning ration? Probably below 10. What does it mean to have little debt? This could be understood as Current Ratio over 2. If the company has all of that, and there is nothing wrong with it- it has a good chance of offering a decent value.
How well does value investing work?
In short- very well. Without giving you links to specific papers (recommended reading is in the end section), it has been shown over and over again that this strategy outperforms the market. The Little Book of Value Investing (Browne) does a beautiful job of listing dozens of studies proving that value investing works, and it works well. The additional thing that makes value investing attractive is the safety it provides. You are not chasing stock that only goes higher and higher to collapse one day. You are making a sensible buy, holding it, waiting for it to raise steadily, but one day- it can just shoot up, once others recognise the value. It is the opposite of risky investment- the surprise that you may see one day in your portfolio, is not a collapse of a stock price, but a total opposite! Buying cheaper stuff is safer than buying more expensive in general, as there is less downside risk.
Where to learn more about value investing?
If you are looking for a set of clear guidance what to do, I invite you to read our recipe for investing like Benjamin Graham! It may sound crazy that a beginner can easily mimic one of the most famous investors of all the time, but it really became much easier lately. We have tools such as equity screeners that make the process way easier.
From books, for the beginner I could not recommend “The Little Book of Value Investing” by Christopher H. Browne highly enough. This is the book that I ask my sceptical friends to read when they are asking me if stock picking is possible for a person without extensive financial background.
Benjamin Graham was already mentioned here- he is the father of value investing and one of the most famous investors of all the time. His “Intelligent Investor” is considered a classing in value investing literature. I think it is worth reading, but I would not make it the first book you read about the subject- it is more technical, and not fully up to date with its examples… It was written in 1949!
When talking about value investing it would be a shame to omit perhaps the most famous investor of our times- Warren Buffet. He was a a student of Benjamin Graham and highly inspired by him. Even though he may slightly deviate from traditional value investing, by his own words he is 85% Benjamin Graham. If you want to know more about value investing, straight from a guy that was made a billionaire by it, I suggest that “The Essays of Warren Buffett: Lessons for Investors and Managers” could be a good place to start.
It is impossible to cover the topic of value investing in one article. This is just the introduction, and in the future you will find much more on the subject here. Good luck in your investing!