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Robert Abbott
Robert Abbott
Articles (686)  | Author's Website |

Value Investing: An Introduction

The advantages, disadvantages and fundamental principles of value investing

January 10, 2020

In his book, “Value Investing: A Comprehensive Beginner Investor’s Guide,” Blaine Robertson aimed to provide a guide for investors who want to learn about the value approach.

Chapter two provided an introduction to the subject, an overview which began with the premise that an investor will select stocks that are selling below their intrinsic value or their book value. Briefly, intrinsic value is based on financial analysis or accounting measures and is not linked to the market or stock price. Book value refers to an accounting valuation of a company’s assets.

Value investing is as much an art as it is a science, since estimating the value of a stock is a subjective matter, demanding what Robertson called “guiding rules.” One of the most important, if not the most important rule, is that investors should buy with a margin of safety; that is, buy at a price well below a stock’s intrinsic or book value.

Value investing’s history

Credit for the term “value investing” and the strategy’s development rest with Benjamin Graham and David Dodd, both professors of finance at Columbia University. Together, they authored the seminal book on value investing, “Security Analysis,” in 1934.

Among their students were several investors who built a widespread value investing community: Warren Buffett (Trades, Portfolio), Mario Gabelli (Trades, Portfolio) and Chuck Royce (TradesPortfolio). Robertson added:

“Over the years, value investing has proven to be one of the most consistent ways of making profits for investors…. Furthermore, they have also established value investing as the most effective modern day economic theory. This is particularly remarkable considering that the concept was fine-tuned around the 1960s.”

The advantages of value investing

The author pointed out that value investors generally stay away from businesses that are doing well because they tend to be fairly priced or overpriced. Instead, they look for stocks of companies going through some sort of turbulence and try to focus on those that are likely to recover—and see their prices recover.

Advantages include:

  • It’s open to everyone: No special educational or financial background is required. In fact, Robertson argued that the minimum requirements are patience and an eagerness to learn.
  • Value investing makes it easy to profit from compounding: Value investors commit their money for longer terms, and time is the essential ingredient of compounding; longer holding periods mean more wealth creation.
  • “Value investing is the smartest way to benefit from the stock market”: Robertson makes this claim on the basis that value investors are less affected by short-term market volatility and avoid the transaction costs incurred with frequent trading.
  • Less risk: This advantage also reflects longer holding periods because price volatility, or turbulence, is reduced over time. Other strategies often suffer because they try to use market timing as they frequently buy and flip stock.
  • The magnitude of errors can be reduced: Value investors can and do make mistakes, but as Robertson wrote, “there is always the opportunity for a do-over.” That advantage arises because value investors buy stocks at a discount (many aim for 30% or more). So, for example, if a company goes bankrupt and its stock plummets to zero, a value investor will lose less than other investors.

Disadvantages

  • Getting the intrinsic value right: One of the methods for determining intrinsic value is by asking how much a sophisticated private investor, with knowledge of the company, would pay to buy the company outright. That sophisticated investor would do lots of financial analysis, but would still need to make subjective judgments because the future is always full of unknowns.
  • Much patience is needed: By its nature, value investing means buying at a discount and then waiting for the price to rebound. That can often take months or years. As Robertson observed, “There isn’t an instant gratification to be obtained with value investing”.

The fundamentals

These are what the author called “the guiding principles, the very foundations that the principles of value investing are based on":

  • Companies have intrinsic value, which is to say a valuation that is separate from market pricing. That intrinsic value remains relatively constant, while market prices fluctuate up and down. When prices fluctuate down, value investors take note.
  • The efficient market hypothesis is often inaccurate: That theory argues that all players in the market have equal access to all available information, and thus stocks should be fairly valued at all times. Value investors, on the other hand, know that prices can be moved by many factors, including external events.
  • A contrarian perspective: Value investors generally like to go against the crowd. They avoid popular stocks (which are often overpriced) and favor unpopular stocks. At least unpopular stocks that are undervalued, but have the potential to recover and become more popular and higher priced.
  • Take advantage of the margin of safety: That is the gap between a company’s real worth, its intrinsic value, and the market price. As noted above, that margin of safety will reduce risk because it provides a cushion against errors in analysis. Not that this is a guarantee or guards against all potential losses, but it can certainly soften the blows.

Conclusion

That’s part one of chapter two; in the second part, Robertson explained in more detail the distinction between value investing and speculation, as well as the distinctions between growth investing and value investing.

In part one, he gave a general overview of value investing, discussed its advantages and disadvantages and outlined the fundamentals, or guiding principles, of this strategy.

If you’re new to value investing, be sure to check out the many thousands of other GuruFocus articles that discuss value investing and its application in evaluating stocks. In addition, members have access to a multitude of tools for analyzing factors such as intrinsic value and margin of safety.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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