Judging from the questions I receive from subscribers there seems to be a lot of confusion as to what exactly value investing is.

A while ago I wrote an article called What is Value Investing?, to clarify my thinking and help you understand the term better.

I recently stumbled onto the article below which explains value investing from a different point of view. It is worth five minutes of your time.


What is Value investing?

Many people throw around the term value investing without an exact definition of what really it means.

Since value investing has become so popular some funds will now call themselves value funds and be nothing of the sort. Some “value” funds own high p/e technology stocks that Benjamin Graham would have never considered anything remotely close to value stocks.

Of course the fund manager will say even at a 50 p/e the stock is still “undervalued”, this argument can be used to say any stock in the world is a value stock. So the question is what really is value investing?

There is no “one” definition of value investing

The thing is there is no simple formula to investing.

With thousands of analyst covering the big cap stocks like MRK (Merck) and KO (Coke), you would not be getting more value by buying Merck at a P/E of 8 vs Coke at a 20 P/E.

This theory largely agrees to the Efficient Market theory, which states that the market incorporates all data immediately, and therefore you cannot beat the market. Many value experts including Bruce Greenwald, Seth Klarman among many others subscribe to this notion.

Seth Klarman in his book Margin of Safety states:

“The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest fora formula that worked would then begin anew. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.”

This value approach does not employ the classic low P/E, P/B, P/CF, high dividend yield etc. for security analysis.
But wait does that mean these investors believe in the efficient market theory, isn’t value investing a contradiction to the theory? Of course they don’t agree completely with it, but they agree partially.


Look where others are not

These value investors believe that you cannot gain an advantage by looking at big cap stocks followed by thousands of analysts. These investors believe the best way is to not fight the crowd but to look for value situations with high margins of safety in obscure places.

These include spin-off’s, bankruptcies, risk arbitrage and small cap stocks in general. These are situations where analysts are not covering and many institutional investors are not interested in and sometimes legally obligated to sell (e.g. some funds are obligated to sell any stock that goes under $5).

The theory sounds good but does it work? The answer is a resounding yes.


Good value managers beat the market

Many of the most outstanding investors have handily beat the market for many decades using this approach including Seth Klarman and Joel Greenblatt.

Greenblatt states that spin-off’s on average have beating the market by a 2-1 margin.

Furthermore, he states that if you look for special value situations which occur in many spin-off’s you can earn much higher rate of return. Greenblatt employed some of these methods returning spectacular 50% annualized returns for over 10 years.


The other school of value investing

What is the the other school of value investing? I would call this the contrarian investing approach made most famous by David Dreman. This approach believes that the stock market (especially in the short term) is driven by psychology.

The best value is in stocks with low P/E, P/B among many other methods to investigate whether a stock is over or undervalued. All this information is publicly available and is true for both small cap and large cap stocks.

So why doesn’t everyone just look for stocks with low P/Es and high dividend yields which can easily be found on a stock screener?


Investors over react to recent news

The reason is investors overreact and place too high a P/E on stocks that have experienced recent earnings growth in recent years.

High P/Es are also placed on certain sectors that are expected to do well over the coming years such as technology. When these stocks don’t match the earning estimates (or even if they match the estimates but investors are no longer willing to pay such a high premium for them since they fall out of favour), they can decline heavily in value.

Does this method also work?

The answer is yes, Jason Zweig in his commentary on the Intelligent Investor by Benjamin Graham states that over the 30 year period ending in 2002 utilities outperformed technology stocks.

Stocks with low P/E and P/B ratios have outperformed higher P/E and P/B stocks over long periods of time not only in America but in virtually every stock market in the world. The reason is that people think alike across the world. Amazon is a lot sexier than Altria, which is constantly stigmatized by lawsuits and laws restricting tobacco use, yet Altria has far outperformed Amazon over the past ten years.

Both value investing approaches are legitimate and provide an investor the chance to outperform the market.

Although by using the contrarian approach it is easier to find stocks that are potential investments, both require full analysis of financial statements.

The first approach is harder but most times the returns are much higher.


The important thing to keep in mind

The most important thing to keep in mind about value investing is to always be disciplined and not driven by emotion, devote time to analysis before investing and to invest in undervalued securities with high margins of safety.

About the Author:
Jacob Wolinsky is a business major at Farleigh Dickinson University. He lives with his wife and daughter in Monsey, NY. He can be contacted at [email protected]

Seth Klarman and David Dreman are great investors. I try to read everything I find on them as it always has something of value.

David Dreman published a great book called Contrarian Investment Strategies – The Next Generation which I highly recommend you take a look at.

Your value investing analyst

PS To find value investing ideas where you invest take a look at our stock screener service

PPS It costs less than a cheap lunch for two and if you do not like it you get your money back. Why not sign up right now before it slips your mind?