The great investment strategies: value investing

Investing expert Julian Hofmann investigates the theory of value investing to understand the lessons for modern investors.

Value investing is simply defined as a method of finding shares that are priced at a level that is intrinsically undervalued by the market. The very first investment book I read as a young investment journalist was plonked down in front of me by a very gruff news editor: “Read this,” he said, “and what you write will be slightly less rubbish.” Mindfulness at work wasn’t really a thing in those days.

However, this turned out to be sound advice for that book was the Intelligent Investor by Benjamin Graham - the bible for investors who look for value in the market. After a series of stressful house moves, it is the only book I have ever bought again after losing – I am now on my third well-thumbed copy – and almost every investment decision I have ever made owes something to Graham.

Continually in print since 1949, the book distils a lifetime’s experience of the markets in an easy and accessible way. And Graham learnt the hard way. His first major treatise Security Analysis was based on his time teaching at Columbia business school in 1928 and came about in the aftermath of the Great Depression and the crippling bear markets of the 1930s. Benjamin proved that with the right mindset and analytical tools, it was possible to find nuggets of real value in what seemed to be the worst possible of circumstances.

Rather than assaulting the reader with a barrage of ratios and formulas, Graham focused instead on a set of useful general rules when it came to defining the ideas behind value investing. The book outlines his philosophy of investing and the psychology of the investor, rather than the technical intricacies of his method.

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The basics of value investing

1. Value is not the same as cheap

It is interesting to note that Graham did not actually coin the phrase value investing, this came later, but most investors understand this concept as referring to common shares that have been intrinsically undervalued by the market. Value investing has seen its definition expanded over the years to include great companies at good prices – which is a good summary of how Berkshire Hathaway has run its recent investment strategy.

At its most basic level, it conveys the idea that shares have a value that reflect factors other than their underlying merits – and the market is not very efficient at pricing those merits.

Graham also highlighted the paradox of quality. Successful companies with good profitability will inevitably command a share price premium over their book value. The higher the premium, the more speculative the investment becomes. Ultimately, the market loses confidence not in the company, per se, but in the premium that the market has assigned it.

2. “There is intelligent speculation as there is intelligent investing. But there are many ways which speculation may be unintelligent.”

Graham puts forward quite a fine distinction between the speculator and the investor. He argues that all investors need to accept that there is an element of speculation in everything that they do. That means keeping speculation within certain limits and preparing psychologically if adverse events force losses on you. However, Graham argues that carrying out the work before committing to buying a share means you won’t be left with a market or “quotational” loss - investors must always operate within “a margin of safety”.

This is about how the mindset of a value investor differs from that of a trader. Value investors “judge the market price by established standards of value”, while speculators “base their standards of value upon the market price”.

3. Growth prospects do not translate efficiently into share values

Benjamin argued against buying shares on expectations of the future growth of their companies or industries. The simplest reason for this is that there is simply no way of knowing which company will break through and thrive. For every Amazon, there were a dozen failed e-commerce companies in the early 2000s. Graham cautions against simply buying a share because the price is rising and selling when it falls – because this is the route to very severe losses in the long run. If investing is at times a popularity contest for the latest trends, or an expression of investor fascination with the story, then valuations will ultimately reflect this.

 If it is fashionable, then best avoid, sums up his approach.

4. Decide what kind of investor you are

On one level, this is about mastering the emotions that investment generates. Allowing exhilaration or despair to govern your decisions will always mean buying expensively and selling too cheaply. Graham explains that this sort of intelligence is a character trait, and so can be learnt, rather than a strict reference to the intellect.

5. The market cancels itself out

“The work of many intelligent minds constantly engaged in this field tends to be self-neutralising and self-defeating over the years.” Graham highlights one of the paradoxes of investor behaviour. Most investors will go into their research with the sense that they can do better than almost everyone who has gone before. The reality is that unless your horizons are very long term and you are prepared to only pay the right price for a share, your losses and profits will tend to merely balance themselves out over a given period.

6. Share prices go up, and down

Graham argues that no serious investor can seriously believe that the daily fluctuations of the market are going to make the investor richer or poorer in the long term. The greed of the general public, of which an investor is part, and an enthusiastic bull market atmosphere means that even the intelligent investor needs huge willpower not to be swept up in the herd.

Getting over this psychological barrier is hugely important for Graham. He recommends giving yourself something to do. For instance, making sales from time to time and rotating them into bonds as the market rises, while doing the reverse as it falls.

“If he is the right kind of investor, he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.”

Further reading:

The Intelligent Investor by Benjamin Graham with commentary by Jason Zweig. Revised edition. Published by HarperCollins.

Securities Analysis by Benjamin Graham and David L. Dodd. Sixth edition. Published by McGraw-Hill.