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By Richard Hunter, Hargreaves Lansdown Stockbrokers
One of the usual traits of "value investing" is that the companies which the investor chooses are - rightly or wrongly - ones which are currently out of favour with the wider market. And, given the volatile and cautious state we have seen the markets enter over the last year or so, there are many companies who could arguably fall into this category. It may not be quite as simple as it sounds - but given the current backdrop in the market, it is probably worth revisiting the idea. "Value investing" was first coined as an investment paradigm in 1934, by the now legendary Benjamin Graham, along with David Dodd. Graham's most famous student is the equally legendary Warren Buffett, who memorably commented on the subject - "Price is what you pay. Value is what you get." However, surely all stocks have value? In the same way that "growth" stocks does not refer to all stocks - after all, investors are buying shares in the hope of future growth - so "value" stocks have more to them than simply having some kind of value. Core to the idea of value investing is identifying the difference between the current market value of the company versus the intrinsic value of the company. The first is easily measured, and is the number of shares in issue multiplied by the share price - in other words, the market capitalisation. The second area, intrinsic value, is where opinions tend to differ. Value investors tend to use a host of different valuation techniques to derive intrinsic value. These often include the "fundamentals", such as earnings per share, Price/Earnings Ratio, gearing, dividend yield and so on. The very fact that these are often based on "leading" indicators rather than "lagging" indicators - that is, future estimates rather than past reported numbers - necessarily introduces an element of risk, because of course future returns can only be assumed. This is the very crux of value investing - that, for whatever reason, the investor believes that the market has either not priced the share correctly or it has not recognised the real value of the company. In addition, set against a benchmark, such as the peers in its sector or even the entire share index itself, a value investor will look for the exact reasons why a share looks "cheaper on fundamentals" than perhaps it should. The difference between the lower market value of a company and the intrinsic value is something which Benjamin Graham labelled the "margin of safety" - imagine offering £9000 for a car which you know to be worth £10000 and having the offer accepted - your immediate margin of safety is £1000. The additional difference (and difficulty) with shares, of course, is that intrinsic value can be measured in different ways. Another aspect of value investing is that it relates to a "bottom-up" approach. Value investors are much less concerned with market sentiment, short term price movements and even to some extent the macro economics at any given time. They are focussed on the fundamentals of the individual business in which they are looking to invest. In addition, they are more concerned with the quantifiable aspects of the company - the numbers - as opposed to the more qualitative and subjective matters, such as the general view of the company's management. Finally, patience. If a value investor buys a stock because he believes it is being undervalued by the market (and he is right) this can still take a substantial amount of time to wash through. Investors such as these are not traders, they will be taking a long term view. Another acid test as coined by Buffett is that value investors should "buy shares on the assumption that the market is going to close for the next five years and that you're happy to leave your money in there." Useful links: |
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