value investing, cheap shares, Benjamin Graham, Warren Buffett

Why you should be a value investor

10.11.2006

by Andrew Van Sickle

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This genius investor does dizzying levels of research to uncover...Half Price Shares!

People should buy stocks in the same way that they tend to buy everything else, says Christopher Browne in The Little Book of Value Investing (Wiley, £13.99): “when they are on sale”. Browne notes that most of the “legends of the money-management business” have pursued a value investment strategy, as opposed to concentrating on fast-growing, fashionable stocks, or growth investing – the other well-established investment approach. This makes sense, given that, as Browne says, value investing is a more straightforward business. “Buy a dollar for 60 cents” and wait until the market recognises that it has mispriced the share and wants it back for the full price.

What is value investing?

So what are the key tenets of value investing, and does it really work? Value investing is rooted in the Great Depression, when Benjamin Graham, the founder of the discipline – and Warren Buffett’s mentor – found that some stocks had fallen so far that he could scoop them up for significantly less than he believed they were worth; he liked to buy stocks selling at two-thirds or less of his estimate of their intrinsic value.

Buying like this provides a “margin of safety” you don’t get with growth shares. It helps prevent nasty bumps when overpriced stocks fall back to earth, should keep a lid on losses in a market rough patch, and increases the scope for gains: you should reap returns from a rerating as well as from a gradual increase in intrinsic value over time.

How to find cheap stocks

Value investors use a wide variety of measures for ferreting out cheap stocks and one of the most popular is book value. This gauge of net worth is calculated by taking everything a firm owns (real estate, buildings, equipment and cash) and subtracting its debts – it was one of Graham’s chief criteria. Browne notes that, between 1970 and 1981, a group of US stocks selling for under 30% of book value would have turned $1m into $23m, compared with $2.6m for the overall market. Stocks selling at low multiples to book value per share have outperformed fashionable fast-growers by between 6.3% and 14.3% a year over periods from 1967 to today – and not just in the US.

It’s a similar story for stocks with low p/e ratios, another way value investors find underpriced stocks. Low p/e stocks have produced far greater returns than their pricey counterparts since 1957 to today, whatever time period you measure it over. So many studies attest to the superiority of value investing that this finding “is among the most robust in all the social sciences”, says Jonathan Davis in the FT.

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Finding low-priced stocks is only a first step, however. You then have to choose the best from among them. Browne suggests avoiding firms heavily burdened with debt and beset by intense competition or costly labour contracts with unions; keep an eye on the trend in revenues and profits over the past few years and consider whether insiders are buying or selling.

Why it's worth being contrarian

Value investors still need to do plenty of spadework, but the key point is to buy cheap in the first place. Oddly, few people do – only around 5%-10% of professional money managers adhere to value investing principles, says Browne. Thanks to the herd instinct, investors succumb to the latest fad; few have the emotional discipline to buy unpopular (and thus cheap) stocks, or the patience to stick with them – sometimes for years – until the market gradually cottons on to their undervaluation. But it’s worth being contrarian. As John Authers says in the FT: “an approach that avoids bubbles and only buys shares when they are cheap will always win in the end.”

For more on value investing, see Merryn Somerset Webb's piece, How to be a value investor like Warren Buffett. Or read A beginner's guide to investment styles for an introduction to a range of investment approaches, including value, growth and momentum investing.