If you’re relatively new to investing, you might find yourself overwhelmed by the myriad strategies and stocks, not to mention the arcane financial jargon. You’ve likely heard terms like "growth," "value" and "momentum" without fully understanding the details of these strategies. Each strategy has merits, but to us, value investing in particular has stood the test of time.
This approach, championed by legendary investors like Benjamin Graham and Warren Buffett, offers a way to build wealth by investors identifying stocks that they believe are selling at lower prices than they ought to be.
But what exactly is value investing, and how can you spot opportunities like the professionals? Below we’ll discuss the basics of value investing and offer practical tips to help you start picking stocks.
Value investing revolves around one simple idea: buying stocks that are undervalued by the market. Imagine you walk into a store to shop for clothes. You find a high-quality designer shirt that’s worth $200, but it’s on the sale rack for 50% off. That’s essentially what value investors aim to do with stocks—they look for companies that they believe are trading for less than their estimated intrinsic value.
The goal is to buy the stock at a low price and hold onto it until the market recognizes its true worth. The theory is that over time, the stock price should rise to align with its intrinsic value and the investor can make a profit.
Value investing isn’t new—it began in the 1930s with Benjamin Graham1, often referred to as the "Father of Value Investing." His 1934 book Security Analysis laid the foundation for value investing, and he elaborated on his strategy in 1949 with The Intelligent Investor. Both remain must-reads for investment professionals, and it’s a rare equity analyst who doesn’t have a copy of Security Analysis on their bookshelf. Warren Buffet, one of the most successful investors of all time, shaped his investment philosophy around the concepts laid out by Graham.
In our opinion, Buffet’s success stands to validate the potential power of value investing. It’s not about jumping on the bandwagon to follow the hottest stock trends, but carefully analyzing companies to find hidden gems. The strategy focuses on the long term, avoiding speculation and irrational exuberance that could lead to losses.
But how exactly does value investing work? Investors often rely on deep analysis, focusing on factors like a company’s earnings, assets, and overall financial strength to estimate the stock's worth. If the stock is trading below what the investor believes is its intrinsic value, it’s considered a bargain.
Value investing isn’t about chasing fads or attempting to time the market. It’s rooted in certain core principles designed to help investors make disciplined and informed decisions.
The concept of intrinsic value is the center around which value investing revolves. Intrinsic value refers to the actual worth of a company based on fundamental financial factors. This includes elements such as revenues, profits, assets, and the company’s potential for future growth.
Value investors can use several techniques to calculate intrinsic value, often relying on financial ratios such as price-to-earnings (P/E ratio) and discounted cash flow (DCF) analysis.
Intrinsic value can be higher than a stock’s market price, particularly when the market is underestimating a company’s true potential. Market downturns and periods of panic selling can also offer opportunities for value investors. Some stocks may be unjustly punished, and investors who’ve done their research can pick up bargains.
One of Benjamin Graham’s golden rules is the concept of a margin of safety. This means buying a stock significantly below its intrinsic value to guard against errors in judgment or unexpected market downturns.
For example, if your calculations suggest that a company’s stock has an intrinsic value of $50 per share but it’s trading at $30, you’ve got a margin of safety. This cushion may help minimize potential losses and could increase your overall returns.
Value investing can help investors avoid the short-term volatility of stock prices and instead focus on the long-term potential of a business. Consider Warren Buffett’s famous quote, "If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes." This mindset helps ensure that value investors tune out market noise and concentrate on holding high-quality investments until their true value is realized.
Successful value investors don’t follow the herd. They’re contrarians by nature, often buying when others are selling, or passing over popular names in favor of more obscure opportunities. This takes discipline and a commitment to doing your own research rather than listening to market hype.
Rather than getting caught up in screaming headlines or short-term price fluctuations, value investors focus on the fundamentals of a business. These include financial health, management quality, competitive advantages, and long-term growth prospects. The idea is to invest in solid companies with sustainable operations.
This strategy isn’t about quick profits or instant gratification. It takes time for undervalued stocks to reach their full potential. A value investor needs iron discipline to stick to their strategy and the patience to wait until the market acknowledges the intrinsic value of the stocks they hold.
There’s a reason value investing has gained a loyal following over the years—it has been shown to work. Several factors make it a compelling choice for investors of all experience levels.
Many of history’s most successful investors have relied on value investing to generate incredible wealth. Their success stories are often the first introduction to value investing, and they serve as living proof that disciplined, value-based investing can yield impressive results.
Let’s look at the numbers. While value, like any strategy, has had disappointing periods, the principle that lower relative prices can lead to higher expected returns remains solid to us. Value premiums can be of impressive magnitude. Looking at the period 1927–2022, in the years when value outperformed growth investing, the average premium was nearly 15%. On average, value stocks outperformed growth stocks by 4.4% annually 1927–2022.2
The emphasis on buying stocks with a margin of safety may reduce the likelihood of significant losses. By ensuring you’re paying far less than an asset's intrinsic value, you create a buffer that has the potential to protect your investment, even if market conditions change.
Unlike speculative investment approaches that may rely on gut feelings or trends, value investing is built on a foundation of logical analysis. It takes the emotion out of investing by focusing on facts and figures. This should appeal to any investor who values clarity and consistency in the investment process.
For retail investors, value investing can be appealing because it seeks to minimize risk. Instead of chasing volatile stocks or taking high-risk bets, value investing encourages investors to stick to solid companies trading at a discount.
Additionally, the strategy aligns well with long-term wealth-building goals. By relying on research and fundamentals rather than speculation, investors gain, even during market downturns.
Value investing is more than just a strategy—it’s a way of thinking. It teaches investors to look beyond the day-to-day noise of market fluctuations and focus on the underlying value of companies.
By understanding intrinsic value, exercising patience, and doing thorough research, you can start to identify stocks you believe are undervalued and seek to build a portfolio that stands the test of time.