Value investing was described in Ben Graham and David Dodd’s book Security Analysis in 1934. It was popularized by Warren Buffet. The purpose of this post is to address the question does value investing work.
What is value investing
Value investing is the belief that assets have an intrinsic value. This intrinsic or natural value of an asset can be approximated by its book value. Book value is the accounting value, that is the price of the asset at purchase depreciated for time. If you buy a computer for 1,000 dollars and it has a life of five years and uses straight-line depreciation in year two the asset is worth 800 dollars. The Book value is 800 dollars. This is clear. The theory is the market value should hold pretty close to book value. This is particularly true if you aggregate the assets for a company as a whole. It is also known as cost investing.
Value investing also considers the present value of all future cash flows of an asset. This is called the discounted cash flow model or DCF. If you have a machine that will produce revenue over the next five years, what is the value of that income stream in today’s dollars considering the time value of money? This is factored into the equation.
Book value investing vs. value investing
Price to Book Value is the classic ratio to look at if you are a book value investor. However, the term value investor has a broader meaning and these people are looking at other things like P/E or price to earnings. Price to cash flow is also used. See the term value investing is loosely applied to many different strategies of investing. Some people even call contrarian investing a form of value investing.
In a general sense value investing is identifying stocks which have a price lower than the instinct value as described above or with some other measure. Book value investors have a greater emphasis on the accounting value of the company.
Where book value investing works best
- Insurance companies that hold large portions of their investment assets in US treasuries. These assets policyholders premium payments kept for future potential payout. These assets held to maturity by definition gravitate back to book value or face value at maturity.
- Companies that are simple and have large amounts of tangible assets.
Where book value investing does not work
- Companies that have large intangible assets, software, goodwill, trademarks, brand names, Internet-based, assets that are hard to value. Accountants will tell you they can value them but they often have no relation to market value, which the stock market is all about.
- What about Warren Buffet? He used good returns in a highly leveraged way in a specific time in the history of the stock market. He leveraged the investment assets of insurance companies. Can you do that?
How has value investing performed?
I have seen studies that show it works and others that show it does not. See each person has their own determinant criterion on the weights they should attribute to different value ratios and indicators. Therefore, there is no consensus. Further on a simple indicator like P/E, some studies say low P/E’s do better and some say high, some say look at P/E momentum and future P/Es. I am sorry I am not giving you a black or white answer but if it was really that easy someone would have modeled it and be a trillionaire by now.
There are even quantitative shops that make their living like ‘value engine or valuengine.com. The graphs look good but if you have to buy the stock with zero transaction cost and buy it before or exactly when they announce a change in their portfolio, and they change it every day as it is a computer model. This makes it hard for the average investor. It also costs about 400 dollars a year. I tried it and never got the same returns they did. In fact, I did better on my own. Therefore, I do not think it is worth it, but try it for yourself. It’s a computer model. It is very hard to come close to getting the returns they have back-tested for. MSN Money has a free valuation engine called stock scouter that has performed better. These valuation tools give you investing information. Read my lips, they just tools, you need a living human brain to use the investment information.
Why I am a value investor and why I am not
Value investing largely ignores market timing. I wrote this article that brings out the importance of market timing and how to do it. Also, value or at least book value investing does do well for the type of investments I like to invest in. However, I use a combination of market timing and some value considerations when making my choices. But really I am not a true value investor. I think all boats go up and down with the tide and the direction of the market is what will determine if you will make a profit in a diversified portfolio. To beat the market you will need a lot more than book value measures.
Use value and cost investment information as a check, with something like stock scouter, but not as a decision-making process, this needs to be based on the market as a whole, management of the company and its direction.
My largest criticism of value investing is because I studied economics and so I am perhaps more of an economist than an accountant (did I mention accountants love this type of valuation of stocks, they need to latch onto something concrete and certain). Economists see price determined subjectively as manifest by supply and demand, not by some intrinsic value. This is the basis of the market and capitalism.
Therefore, does value investing work? No. It is nothing special. Use value investing plus your own personal evaluation of the direction of the company and management and you have a good strategy to put money and capital into the equity markets and make a profit.