What Is Value Investing?

Value investing is an investment strategy where stocks are picked based on the fact that they appear to trade for less than their intrinsic or book value. Value investors actively seek out the stocks they believe the market has undervalued. Investors employing this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. This overreaction offers value investors an opportunity to profit by buying stocks at a discounted price.

Warren Buffett and Peter Lynch are two notable value investors. By analyzing financial statements and looking at valuation multiples, they seek to identify cases where the market has mispriced stocks and ultimately capitalize on the reversion to the mean.

Value investors assume the efficient-market hypothesis is false and that stocks don't always trade at intrinsic value.

How Value Investing Works

Undervalued stocks are thought to come about through investor irrationality. Value investors hope to profit from this sort of irrationality by investing in companies which may have below average valuation multiples, such as price-to-book (P/B) and price-to-earnings (P/E) ratios.

After a review, the value investor will then decide to purchase shares if the comparative value is attractive enough. However, this task is not so easy in practice. Estimating the true intrinsic value of a stock is more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions.

Because of this, value investors often set their own "margin of safety" based on their particular risk tolerance. Value investors require some room for error in their estimation of value and will seek to purchase shares they perceive are deeply discounted.

Key Takeaways

  • Value investing came from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934.
  • The strategy includes buying stocks that are underpriced, and therefore trade at less than their intrinsic value.
  • Berkshire Hathaway leader Warren Buffet is perhaps the most well-known value investor.
  • Studies have consistently found that value stocks outperform growth stocks and the market as a whole, over long time horizons. 

Requirements for Value Investing

To utilize a value investing strategy one must assume the efficient-market hypothesis is false, which says that all available information is already priced into the cost of a stock. Stocks, based on a value investor’s perspective, can be over- or underpriced for a variety of reasons.

This could be due to psychological biases that push a stock up or down based on news. This bad or good news could come in the form of an earnings announcement that disappointments or surprises, or a major announcement, such as a recall or litigation announcement. Then there’s the idea that stocks can be undervalued because they trade under the radar and aren’t covered heavily in the media or by analysts.

Value investing is a subjective process. Some investors will look only at existing financials and do not put much faith in estimating future growth. Other value investors will focus primarily on the future growth potential and the company's estimated cash flows. Despite different strategies to the approach, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them for the long-term, and profit when they return to the intrinsic value or above.

One-Third

Value investing guru Benjamin Graham argued that an undervalued stock is priced at least a third below its intrinsic value. 

The Art of Value Investing

The key to buying an undervalued stock is to thoroughly research the company and then apply your common sense and critical thinking skills.

Value investor Christopher H. Browne of the legendary value-investing firm Tweedy, Browne recommends asking a series of questions about a company, in his book “The Little Book of Value Investing.” Think about the company’s future prospects — can the company increase its revenue by raising prices? Increasing sales? Lowering expenses? Selling or closing unprofitable divisions? Growing the company? Who are the company’s competitors and how strong are they?

What you think the answers to these questions are is where value investing becomes an art form. It’s also why you can’t just plug some numbers into a software program to determine the best value stocks to invest in. You’re making predictions — educated guesses — that may or may not pan out.

To increase your odds of accurately answering the questions above, buy companies that you understand. Warren Buffett takes this approach. Companies that you understand will most likely be in industries you have worked in or that sell consumer goods that you are familiar with, like cars, clothes appliance and food. Well-known investor Peter Lynch strong advocated such a strategy, whereby retail investors can outperform institutions simply by investing in what they know before Wall Street catches on.

Another strategy is to buy companies whose products or services have been in demand for a long time and are likely to continue to be in demand. It’s not always possible to predict when innovation will make even a longstanding product obsolete, but we can find out how long a company has been in business and how it has adapted to change over time. One way is to analyze the company's management and the effectiveness of its corporate governance to determine how the firm reacts to changing business environments. A firm with a track record of evolving in the face of change may be a good bet.