What Value Investing Is Not Buying a Stock for Less Than Its Calculated Value is not value investing. Surprisingly, this alone sets value investing apart from the majority of other investment strategies.
True (long-term) growth investors like Phil Fisher solely focus on the company’s value. They only want to buy shares in businesses that are truly extraordinary, so they don’t care about the price.
They believe that these businesses will be able to benefit from the wonders of compounding due to their phenomenal growth over many years. Even a price that seems high will eventually be justified if the company’s value increases rapidly and the stock is held for a sufficient amount of time.
Relative prices are taken into account by some so-called value investors. They base their decisions on how the market values other publicly traded companies in the same industry and each dollar of earnings in all businesses. In other words, even though the P/E ratio may not appear particularly low in absolute or historical terms, they may decide to purchase a stock simply because it appears to be cheap in comparison to its peers or because it is trading at a lower P/E ratio than the general market.
Should this strategy be referred to as value investing? I do not believe so. Despite the fact that it is a distinct investment philosophy, it is a perfectly valid one.
The calculation of an intrinsic value that is independent of the market price is necessary for value investing. Value investing does not include strategies that are based solely (or primarily) on empirical evidence. A logical structure is built on the tenets outlined by Graham and expanded upon by others, such as Warren Buffett.
Graham established a highly logical school of thought, even though value investing techniques may have empirical backing. Prior to verifiable hypotheses, correct reasoning is prioritized; and correlative relationships are emphasized more than causal ones. Quantitative value investing is an option; However, it is quantitative mathematically.
Calculus-based quantitative fields of study and pure arithmetic-based quantitative fields of study are clearly and consistently distinguished. Security analysis is treated by value investing as a strictly mathematical discipline. Despite the fact that Graham and Buffett were both well-known for having greater natural mathematical abilities than the majority of security analysts, they both stated that higher mathematics should not be used in security analysis. Only basic math knowledge is required to engage in true value investing.
Contrarian investing is sometimes referred to as a sect of value investing. In practice, those who identify as value investors and contrarian investors tend to purchase stocks that are very similar to one another.
Let’s take David Dreman, the author of “The Contrarian Investor,” as an example. David Dreman is known for being an unconventional investor. Because of his strong interest in behavioral finance, it is a good description for him. However, the distinction between value investors and contrarian investors is usually at best hazy. The following three metrics are used to derive Dreman’s contrarian investing strategies: value in relation to earnings, cash flow, and book value. Value investing, specifically so-called Graham and Dodd investing (a type of value investing named after the co-authors of “Security Analysis,” Benjamin Graham and David Dodd), is closely associated with these same metrics.
Conclusions In the end, the only way to define value investing is to pay less for a stock than its calculated value when the method used to calculate the stock’s value is truly unrelated to the stock market. The estimated intrinsic value is not affected by the stock market if the intrinsic value is determined by analyzing asset values or discounted future cash flows. However, value investing is not achieved by simply purchasing stocks at low price-to-earnings, price-to-book, and price-to-cash flow multiples in comparison to other stocks. Obviously, these tactics have worked well in the past and probably will continue to do so in the future.
One such efficient method is Joel Greenblatt’s “magic formula,” which frequently produces portfolios that resemble those of genuine value investors. But Joel Greenblatt’s magic formula doesn’t try to figure out how much the bought stocks are worth. Therefore, although the magic formula may work, it is not true value investing. Because he does calculate the intrinsic value of the stocks he purchases, Joel Greenblatt is himself a value investor. The readers of Greenblatt’s The Little Book That Beats The Market were investors who lacked the ability or desire to value businesses.
If you are not willing to calculate business values, you cannot be a value investor. Although you are not required to precisely value the company in order to be a value investor, you are required to value the company.
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