The concepts of value investment were developed in the 1920s and 1930s by Benjamin Graham and expounded in two classic books “Security Analysis” (1934) and “The Intelligent Investor” (1949). Both are still in print today. Most UK investors have not heard of Benjamin Graham. Perhaps a hint of his pedigree can be conveyed by the following: He was one of the most successful investors in history and he was the tutor of Warren Buffett.
The potency of classical value investment rests on the distinction between a company’s market value and its intrinsic value. A company’s market value (or market capitalisation) is simply a function of its share price. But a company’s intrinsic value is a complex measure of the overall vitality of the business and requires detailed research to assess. Consideration must be given to all aspects of a company’s situation including its profitability, its sustainability, the level of competition in its market(s), its historical performance and, above all, the value of the assets (such as cash, land and property) that it owns.
In the short term, emotional factors such as fear and greed often drive share prices. But over the longer term, it tends to be the underlying strengths and weaknesses of the company that are represented in its intrinsic value that tend to have the greatest effect on a company’s market value.
The value investor therefore seeks to uncover quality companies that are currently, for whatever reason, trading at a substantial discount to their intrinsic value. That is, they are substantially undervalued by the stock market. The value investor will buy such companies believing that, over the longer term, their underlying strengths will become apparent and will cause their share prices to increase dramatically. Once the market value has risen to reflect the intrinsic value (the company is no longer undervalued), the value investor will sell.
As a result of the focus on intrinsic value, classical value investing tends to be a very grounded investment strategy. Detailed research is done to reduce the risk of making each investment. But historically, classical value investment has outperformed other investment strategies. Perhaps its success can best be summed up in the fact that the value investor strives to do what every investor should be doing – to buy when prices are low and sell once they have appreciated dramatically.
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