What is Value Investing?

by | Jun 12, 2020

Value investing is an investment strategy where you aim to buy stocks for less than their intrinsic value. Intrinsic value is another way of saying true value. 

It is a strategy practice by some of the most successful investors both past and present such as Warren Buffett, Benjamin Graham, Seth Klarman, and Joel Greenblatt. 

How does Value Investing Work?

Value investing works because the market overreacts to news both good and bad. This causes the stock price to become disconnected to the companies value. When news is bad the market may overreact by selling the stock down to a price that is undervalued. Stock is undervalued when its price is less than it’s intrinsic value. This can give value investors an opportunity to buy the stock for less than what it is worth. When good news comes out the market may overreact by driving the stock up to a price that is overvalued. A stock is overvalued when its price is greater than its intrinsic value. This can give value investors a chance to sell for a profit. 

Let’s look at an example. 

Company XYZ has an intrinsic value of $100 and a price of $100 per share. This stock is fairly valued. A news story breaks that Company XYZ is going to be sued by a rival company. The market overreacts to this story by selling the price down to $50. You are a clever value investor and realize the legal case is going to have very little effect on the long term fundamentals of the company. You decide to buy the stock because it is essentially on sale at 50% off. A few months go by, people forget about the legal case and the price slowly rises back up to $100. Another news story breaks that the rival company is dropping its case. The market overreacts by driving the stock price up to $150 per share. You decide that this price is too overvalued and sell. You make a tidy $100 profit per share and a 200% gain. 

Why Stocks can Become Undervalued.

There are multiple reasons a stock may become undervalued, here are some of the most common reasons. 

  • Economic Recession – such as when the dot com bubble burst in the early 2000s, the 2008 Global Financial Crisis, or the COVID-19 outbreak. This will present buying opportunities through the market. 
  • Industry recession – even though many stocks were affected by the COVID-19 outbreak the hardest hit were those in the travel, tourism, and hospitality industries. Industry recessions will present buying opportunities in that particular industry.
  • Short term correction – Sometimes the market will drop by 10 – 15% for a few weeks or months such as in December 2018. This will present buying opportunities throughout the entire market. 
  • Bad news – Sometimes an individual company will be hit by some bad news. This will present a buying opportunity for that company. 
Value Investing Opportunities on the S&P 500 since 1995

Arguments Against Value Investing

The biggest argument against value investing comes from believers of the Efficient Market Hypothesis. The efficient market hypothesis states that all available information is always and immediately priced into the stock and so they are always correctly priced. This means that no stocks are ever over or undervalued. 

While it is likely that most stocks are correctly valued most of the time it is now widely accepted that stocks do go through periods of under and overvaluation. 

Famous Value Investors 

Warren Buffett

Warren Buffett is one of the wealthiest men in the world with a net worth over $70 billion.

Buffett has achieved over a 20% compounded annual return since 1965.  

Benjamin Graham

Known as the ‘Father of value investing’ Benjamin Graham is the author of the value investing bible ‘The Intelligent Investor’. He was Buffett’s professor and Columbia University. He achieved compounded returns of over 20% from 1936 to 1956.

Joel Greenblatt

Joel Greenblatt is the author of investing books such as ‘You can be a Stock Market Genius’ and ‘The Little Book that Beats the Market’. He achieved an annual return of over 40% from 1985 to 2006

Summary 

  • Value investing is an investing strategy where you aim to buy stocks for less than what they are worth.
  • Value investing works because the market overreacts to news both good and bad.
  • Opportunities to find value stock can arise due to global recessions, industry recessions, short term corrections, or bad news. 
  • Believers in the Efficient Market Hypothesis believe the value investor strategy doesn’t work. 
  • Warren Buffett, Benjamin Graham, and Joel Greenblatt are all successful value investors you may want to learn more about.

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