Benjamin Graham is considered to be the father of value investing strategy.
But what is value investing and how can it create meaningful wealth for investors?
Graham’s value investing strategy was to use a business’s metrics to determine its true value, which often times was significantly higher than the market price of its shares.
Of course when stocks have an intrinsic value that is much higher than its market price, that is a time to buy shares in that company. After buying into a company, value investors will wait for the market to come to understand the true value of the business, resulting in a higher stock price.
This value strategy today is used by Warren Buffet and Charlie Munger to name a few. In addition, today there are hundreds of value funds in the mutual fund industry focused on value investing with varying degrees of success.
In the 1930s, Benjamin Graham was a professor at the Columbia Business School. Graham and fellow professor David Dodd published their first book on value investing strategy in 1934.
Their idea was that investors needed to look for stocks that were trading significantly below their book value (assets-liabilities) or below tangible book value (assets-intangible assets-liabilities). The further the company’s stock traded below the book value of the companies shares, the more the margin of safety was for investing in the stock.
As you can tell by the calculation above and other factors that Graham used, he was more reliant on the quantitative aspects of a business, rather than the qualitative factors like the management team or competitive forces.
Graham went on to write other books, perhaps the most popular was The Intelligent Investor, which he published in 1949, which further detailed his teaching on what was later called value investing.
Warren Buffett and Charlie Munger in more recent years been seen as a beacon for value investors with the success that they’ve had with Berkshire Hathaway. Buffett was a disciple of Benjamin Graham’s teachings.
Since making a modest investment in Berkshire Hathaway in 1965 Buffet and Munger have acquired more than 60 companies to create a conglomerate with a market capitalization of more that $500 billion.
Much of this value was created by buying companies below their intrinsic value, creating a large margin of safety and building shareholder wealth. Buffett is reported to be worth more that $100 billion and Munger is reported to be worth more than $2 billion.
And while Berkshire Hathaway is an extreme example of value investing done well, it illustrates how powerful the concept can be for investors net worth.
As value investing can work wonders for the value of your net worth, in recent years there has been more focus on growth stocks.
Value vs. Growth stocks in 2021 is a hot topic. We are seeing more investors cycle out of growth stocks and putting more focus on a value investing strategy. In order to determine, which strategy is more viable at a certain time, it’s crucial to understand the difference.
To paraphrase some of the value stock strategies discussed above, value stocks generally have lower price-earnings ratios, tend to pay a dividend and likely are growing at a rate that is lower then the average stock in the market. Think of companies like Viacom with a price earnings ratio below 10.
Growth stocks in the other hand are growing at a rate that is usually higher then the market averages. Think of fast growers like Amazon, Apple, Google/Alphabet to name a few. Generally, these kind of growth stocks get more press because their brands are better known and they are performing quite well creating shareholder value.
The challenge with growth stocks is that there is no margin of error if the growth rates of the businesses suddenly slows. That is a painful time for growth investors as the stock price will contract to the new value based on the slower growth rate.
It is this lack of margin of error with growth stocks that creates value investors who look for companies that they KNOW are worth more than their current value. All they need to do is be patient and wait for the rest of the market to realize it and watch the stock price increase to the point of the real value.
Once you have come to this determination, the value investing vs. growth investing debate becomes less black and white and more complimentary of each other.
If you Identify as a Value Investor, Let’s Talk Strategy
Strategy #1 – Look for Companies that are Trading at Market Prices Below Their Intrinsic Value
This value investing strategy is for investors who have the skill and the time to review balance sheets, income statements and statements of cash flow to look for companies whose real value is much higher than the current market price as determined daily by investors and traders on the open market.
There are many reasons why businesses sometimes trade at a market value that does not reflect the true value of the company. Industries fall out of favor during certain parts of economic cycles, and in fact individual companies can fall out of favor due to macroeconomic factors, or because they miss their quarterly financial goals for a couple quarters in a row.
Start by looking at companies and industries where the price to earnings ratio is well below the market averages. Viacom, mentioned above, trades at less than 10 times earnings per share, when the overall market is trading closer to 20 times earnings. This is a high-quality value stock. The banking sector is also quite undervalued relative to the overall market. Another place to look for value stocks.
But value stocks don’t just need to be low price-earnings ratio stocks. Facebook (ticker “FB”), is a stock we like very much. It is trading at about 21 times next year’s earnings, which approximates the overall market, but is growing much more quickly. So in some circles, even though Facebook is not a low price earnings ratio stock, it still could be considered a value stock.
Often times value investors look at a company’s balance sheet to determine if there is value to be had. As an example if the assets minus liabilities is greater than the market capitalization of the stock, then that company is a prime candidate for further research as to whether shares should be acquired as a value investment.
Strategy #2 – Maybe a Value Fund (Mutual Fund) is Right for You
Many investors, if they are honest with themselves will say that they either do not have the time or skillset to pour over financial statements to determine the real value of a business and compare it to the market capitalization to see if there is a value investment to be made.
If you are in this category, then congratulations for being honest with your self-assessment. An excellent value investing strategy for just such a person, is to invest in a value fund. Here is a great value mutual fund to put on your shopping list.
T. Rowe Price Value Fund (ticker TRVLX). T. Rowe Price is of course a well respected financial firm with large volumes of assets under management so you are in good hands.
The T. Rowe Price Value Fund “invests in bargain stocks that offer an opportunity for capital appreciation as other investors recognize the company’s real value”. This sounds like the truest form of value investing preached by Graham and Buffett above.
With a fund size of $34 billion and a ten year average return of 12%, I would say this fund is doing a lot of things correctly when it comes to value investing.
Significant holdings of the T. Rowe Price Value Fund include Morgan Stanley, GE, Applied Materials and Wells Fargo, all of which we would consider to be underpriced value stocks.
In Summary
Growth investing and value investing are two significantly different ways to make money investing in stocks of high quality businesses. Both methods are viable for different types of investors.
Growth investors look for companies in industries that seem able to grow in significant ways over multiple decades.
Value investors look for companies that are temporarily trading below their intrinsic value, and hope to profit as other investors come to understand the merits of the company.
If you are going to be a value investor you need to go in with a strategy. That entails either being comfortable looking through financial statements to spot signs that a company is a viable value investment. Or investing in a value mutual fund that will do the stock research and selection for you.
If you are a value investor, be sure to know whether you are qualified to do the work yourself or feel comfortable with a mutual fund management team doing the work for you.
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