Value Investing – Definition, Core Tenet and Principles
There are multiple definitions of value investing promulgated by different individuals and organizations. There is no authoritative definition; however, there are several intelligent, well thought out, and comprehensive responses. Here are some examples:
Investopedia – “Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating”.
Wikipedia – “Value investing is an investment paradigm that involves buying securities that appear under priced by some form of fundamental analysis.[1] The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham and David Dodd at Columbia Business School in 1928, and subsequently developed in their 1934 text Security Analysis“. Benjamin Graham developed a formula to calculate a stock’s market value as a part of the text.
Forbes’ Rob Berger – “Value investing is nothing more or less than buying investments on sale”.
Wharton School of Business – As written by Donald B. Keim, PHD in an article written on November 3, 2017, Is Value Investing Really in the Doldrums? “In general, value investing looks to buy shares of companies trading lower than their intrinsic values. As such, value investors seek to buy financially solid companies at a discount, …”.
The definition of value investing is elusive, more so because it is more of a concept than an actual formula or derivative. It goes beyond just owning stock at a good price, i.e. trading less than intrinsic value; it also refers to selling stock when the market price exceeds a reasonable value for the stock. In effect, value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery. The difference is a gain improving the investor’s wealth.
Simply stated, the core tenet is ‘BUY LOW, SELL HIGH’.
Furthermore, value investing relies on four principles for success. It includes risk reduction by investing only in high quality stocks, not just any stock no matter how cheap it appears. Thus, penny and small cap stocks are excluded from a value investor’s selection portfolio. Secondly, select stocks with solid underlying assets; this is referred to as purchasing stocks with intrinsic value. Third, use financial analysis, specifically business ratios and key performance indicators to identify worth and trends. Finally, all value investors must understand timing related to buying and selling stock. The key to timing is patience. By reviewing the historical market price pattern for the respective stock, a value investor gains greater confidence and can determine the best buy and sell points to maximize value.
Value Investing = Buy Low, Sell High
In business, there are several universally applicable principles called tenets. These principles are undeniable and exist in every aspect of business acumen. The most central of all tenets is the buy low, sell high doctrine of business. It is focused on profit, the most desired outcome of all transaction activity for entrepreneurs and business minded individuals. Value investing utilizes the same concept. However, in general, value investing as a term is used related to market investments and not the day-to-day operational decisions made in business. Value investing is most commonly used as a term with the buying and selling of securities, primarily stock.
The problem with the buy low, sell high definition is that it is inherently flawed. Even when an individual buys something for a low price, it doesn’t mean that the price will rise in the future. There is also risk; primarily that the price will not rise or even rise within in reasonable period of time to receive a good return on one’s investment. Thus, although the core tenet is to buy low and sell high, without adherence to some principles, losses are inevitable. Therefore, the definition for value investing must be refined in scope and include risk reduction.
Risk Reduction
Risk reduction with stock only exists with long-lived, well established and well managed companies. Of course, there is one group of companies that fits this definition well; that is the group of 30 most valuable (market capitalization) companies, commonly referred to as the DOW Jones Industrial Companies or DOW for short. The DOW consists of the top 30 large market capitalization companies traded on the exchanges. There are others, but the DOW index is the standard to measure performance against.
Value investing requires a stricter definition. It means to buy low, sell high with less riskier stock investments. This is achieved by investing in larger, specifically large or mid capitalization stocks. The problem with this concept is that these types of stocks tend to have steady prices and rarely behave in a volatile manner; for that matter, they rarely flucuate more than 10% in any direction in a short period of time. The end result is that it is difficult to find opportunities to buy low and then sell that stock at a higher price. This doesn’t mean it can’t happen, but when it does; the value investor takes advantage of the opportunity.
To make value investing work, the pool of well-managed companies must be broader in scope. Thus, value investors try to keep their investment to the S&P 500 companies which aggregated is about two-thirds of the entire US Economy. With the most recent list, the #1 company is Apple which also is a DOW company with a market capitalization of almost $2 Trillion. Apache Corporation is number 500 and its market capitalization is around $3.3 Billion. These 500 companies present as potential value investment opportunities because they have good histories behind them; thus, risk is lower than other potential investments.
Intrinsic Value
Thus far, value investing refers to a process of buying low, selling high with low risk investments. However, this still isn’t a pure definition. Why? Even if you buy low, it still doesn’t reflect the possibility that the stock will go continue to decrease in market price. Therefore, what a value investor is really seeking is to buy quality stock at a low price and it is backed by intrinsically stable value based assets. This acts as insurance to keep the price from continuing to drop or acts as pushback against decreasing market prices.
Intrinsic value refers to the dollar value of the net underlying assets of a company. Current and fixed assets are commonly considered intrinsic with dollar values, i.e. the market will pay reasonable amounts if the respective assets are sold as individual assets; like selling pieces of a pie. However, there are assets that are not as liquefiable nor as valuable as the recorded value on the books of record for the company. Good examples include intangible assets such as development costs, copyrights etc. Markets for these types of assets are not as readily available in comparison to markets to sell inventory or land. In some cases, there is no market for the respective intangible asset. Thus, value investors stay attune to the intrinsic value of their respective investments.
The best example of investments with solid stable priced assets include those companies involved in real estate (REITs, Hotels, & Resorts); utilities, transportation, mining, and big ticket item manufacturing (automobiles, appliances and electronics). For all of these companies, these assets are reported as fixed assets on the balance sheet. When fixed assets comprise more than 80% of the asset value on the balance sheet there is a strong intrinsic value position for the stock.
Value investors may seek out low risk companies with deep discounts in their market price, but without good underlying assets to back up the value of the respective stock price, it is possible that the market price will continue to slide lower. For example, look at the assets side of the balance sheet of Johnson & Johnson in comparison to Union Pacific Railroad at 12/31/2019.
(In $ooo’s) Johnson & Johnson Union Pacific
Current Assets 45,274,000 3,459,000
Fixed Assets 17,658,000 55,728,000
Other Assets 94,796,000 2,486,000
Total Assets 157,728,000 61,673,000
Johnson & Johnson is a DOW company, Union Pacific is not. One company is consumer driven, the other has large industries as its customer base. Johnson & Johnson’s fixed asset portion is 11.2% of the portfolio of assets whereas Union Pacific’s fixed assets exceed 90%. Neither company lost money during the 2008 – 2011 recession time frame. However, a value investor looks at both entities and ask a fundamental question – Which company has a greater possibility of going out of business? It is very unlikely that neither will go out of business; both are high quality stocks. But the key question is: Can the stock price continue to decline from an already low market price?
During the stock market decline in March of 2020, driven by the COVID pandemic, Johnson & Johnson’s price drop to 79 percent of its prior peak price and Union Pacific dropped to 67 cents on the dollar from its prior peak price. At this point, both were very good opportunity buys for value investors. The question is, which one had more risk for the price to continue dropping: the consumer based company or the industrial based company? Both have strong assets portfolio to push back against continuing declines in the stock price. But the reality is this, the heavily weighted fixed assets portfolio of Union Pacific is better insurance against deeper price declines than Johnson & Johnson’s reliance on goodwill and other intangible assets.
For those of you that are younger than age 50, back in 1982, there was a Johnson & Johnson situation involving Tylenol. Basically, seven people died from some nutcase injecting poison into Tylenol. Before identifying this as a terrorist act, the public perceived this as a process issue with Johnson & Johnson. The share price for Johnson and Johnson dropped 30% within a few days; some investors thought Johnson & Johnson was doomed. However, once the facts came out and of course the steps Johnson & Johnson took (inventing the child proof cap plus a thin film on top of the bottle), the public trust was restored. This took a couple of years though.
Again, which stock investment has less risk of continuing market price declines? Value investors will always select the stock with a strong fixed assets position over stocks tied to intangibles or slow liquefiable current assets; especially if those fixed assets have a readily available market to sell them, such as real estate, transportation or heavy equipment.
There are still two more aspects of value investing that every investor must understand.
Financial Fundamentals
The third and essential principle of value investing is reliance on sound financial information. Most of this information is presented in the form of various business ratios. The respective ratios are weighted and trend lines are charted. The goal, verify and validate sound financial practices. What exactly do value investors look for with financial information?
- Solid and consistent net profits over many years;
- High gross margins indicating sound operations;
- Good asset maintenance and replacement schedules;
- Continuously improving debt ratios;
- Consistent sales charted over long periods of time (> 20 years)
Once financial performance is established, the value investor looks for other pertinent data to substantiate financial performance and act as a gauge during the current interim accounting period. These are known as key performance indicators. For example, many large railroads report the number of carloads or revenue tonnage transported each week. This allows existing shareholders, institutional buyers and market watchers an opportunity to evaluate operations which ultimately affects sales and the gross margin percentages.
With this financial information, along with some valuation ratios, a value investor can then set buy amounts and sell points for the respective potential or existing stock purchase.
All of this is for naught without a clear understanding of timing and its impact on a value investor’s return on their investment.
Patience
Time is the fourth principle of value investing. It really isn’t so much as time, as it is really patience. The key to value investing is to set buy and sell price points for members of a pool of similar stock investments. Once those buy and sell points are set for the respective companies in the pool, the value investor takes advantage of modern technology and provides computer orders to their respective broker. If one of the stocks has a sudden market price decrease or increase depending on a buy or sell directive; the computer order automatically carries out the directive. Thus, the value investor must be patient with their analysis and the corresponding buy low/sell high price structure.
As an example, with one particular pool discussed and explained on this website – railways, there are six publicly traded Class I railroads. All six have similar financial characteristics:
- All generate a profit, the lowest net profit within the group is 22.8% (prior to Oct 2019);
- All have positive operational cash flow and good free cash flow;
- All issue dividends to their shareholders;
- All have gross profit margins > 34.5% with the average over 37%;
- All have low administrative overhead generating high operational profit margins;
- All have similar 10 year growth lines related to share price.
All six are evaluated against at least a dozen business ratios along with several valuation ratios. With this information, each railway is evaluated for their respective buy and sell stock price over the forthcoming year. Orders are then given to the broker and now the value investor simply waits. During October 2019 to September 2020 time period (one year) the fund made only five full buy/sell transactions and earned a 23.52% return on the original investment (net of all transaction fees). The pool is then reevaluated and the process starts all over again for the new one year cycle.
Naturally, there is more to it than this. Time can work for the value investing and it can also be the worst enemy. If a certain stock has very short time cycles between the buy and sell point, earnings are quick and the value investor has a faster turnover rate increasing the effective return on the investment. Whereas, longer cycles can significantly reduce the effective return rate. All of this is evaluated in the financial analysis to determine optimum buy and sell points and what to expect in terms of frequency of buy/sell activity.
One of the most difficult aspects of value investing is waiting for a trigger. Calm heads prevail with value investing. If a value investor does their research work properly and exercises reasonable expectations, returns on investment will always outperform all the major indices.
Summary – Value Investing Definition, Core Tenet and Principles
Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
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