Value Investing

Value investing is an investment strategy that deliberately overweights shares trading at low prices relative to a measure of the underlying business, in the judgment that the market has underpriced them. FINRA describes it as buying securities that, on fundamental analysis, are "trading below their intrinsic worth or at a discount to the market or their peers", and states the premise behind it: "if your holdings truly represent good value, the market will eventually adjust to reflect this."

A naming note, because two of our pages cover one subject. "Value stock" names the classification and "value investing" names the act of building a portfolio around it. The value stock page covers what the label means and how it fails; this page covers what running the strategy involves. Neither is the official term, because there is no official term: the strategy is described by regulators rather than defined by them.

The strategy has two distinct forms, and confusing them is the commonest mistake a reader makes about it. The first is mechanical. A screen ranks a large universe of companies on one or more ratios, the cheapest slice is bought, and the list is rebuilt on a schedule. Nobody reads the filings and nobody forms a view about any individual business; the position is a bet that the slice as a whole is underpriced. The second form is the opposite: a small number of companies, each one examined in detail, held because the investor has reached a specific conclusion about that specific business. Both are honestly called value investing. The mechanical form carries the risk that the slice contains a great many deteriorating businesses at once; the concentrated form carries the risk that one judgment about one company is simply wrong, with far less to absorb it.

What FINRA calls patience is the part that is actually hard. FINRA says "value investors expect to be rewarded for their patience" and warns that "it might take years for the broad investment community to change its sentiment regarding out-of-favor stocks." That is a statement about the investor, not about the companies. A strategy whose payoff arrives after an unknown number of years of looking wrong only works for someone who is still holding it when the payoff arrives, and the position is by construction the one that is least comfortable to keep explaining to yourself. An investor who abandons the approach after a poor stretch has taken the strategy's cost and left before its return.

The cyclicality is documented rather than anecdotal, and it is the reason the two labels are usually taught together. FINRA's own stock-types material states that a common approach is "to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness." Read carefully, that sentence is doing two things. It says the relative performance of the two swings, and it says a mixture is a recognized answer rather than a fence-sitting one. Value investing is not the prudent option and growth investing the speculative one; they are two positions on the same question, and each spends time out of favor.

Buying cheaply is a cushion and not a guarantee, and FINRA states both halves. On the cushion: "even if your view of a company's prospects proves optimistic, buying at a low valuation can help cushion the downside." On the limit of it: "not every stock with a low P/E or P/B represents true value. Sometimes stocks sell off due to a deterioration in their fundamentals that's not yet commonly understood." The idea that a low purchase price leaves room to be partly wrong is the strategy's core defensive claim, and it is the same idea that lets a falling business look like an opportunity right up until the earnings arrive.

Where this page stops. The measures a screen uses, and their individual weaknesses, belong with the ratios themselves. The idea of an intrinsic value that a price can be compared against, and the accounting value of a company's net assets, are each a subject in their own right and are named here rather than built here. The academic literature that treats cheapness as a systematic, compensated exposure across whole markets is a different framing again, and it is not the retail strategy described on this page.

An investor picks the measure or measures that will define cheapness, applies them across a universe of companies, and buys the companies that rank cheapest, either directly or through a fund built on the same idea. The position is then held while the market's opinion either changes or turns out to have been right. The rebuild schedule, the number of holdings, and whether anyone reads the filings are what separate one implementation from another.

A hypothetical illustration of the cushion FINRA describes, and of its limits. Two investors each put $10,000 into a single company. Ivo pays $50 a share for 200 shares of a company earning $5.00 a share, so he pays ten times earnings. Marta pays $100 a share for 100 shares of a company earning the same $5.00 a share, so she pays twenty times earnings.

Suppose both companies later earn $4.00 a share instead, a disappointment of the same size for each, and suppose the market keeps paying each of them the multiple it was paying before. Ivo's shares are worth 10 × $4.00 = $40, so his 200 shares are worth $8,000 and he has lost $2,000. Marta's are worth 20 × $4.00 = $80, so her 100 shares are worth $8,000 as well, and she has also lost $2,000. Identical outcomes, which is the point worth noticing: the lower price alone did not protect Ivo from an earnings disappointment.

Now change one thing. Suppose the market decides Marta's company no longer deserves twenty times earnings and repays her the same ten times Ivo gets. Her shares are worth 10 × $4.00 = $40, her position is worth $4,000, and she has lost $6,000 against Ivo's $2,000. That second loss, the multiple falling rather than the earnings, is the exposure a low purchase price genuinely reduces, because there is less multiple left to lose. All figures are illustrative.

Pros

• The case rests on figures a company has already reported rather than on forecasts of results that have not happened.
• Paying a lower multiple leaves less room for the multiple itself to fall, which is a real and specific form of protection.
• The approach is implementable at low cost through a fund, so it does not require the investor to read filings to hold the position.
• FINRA treats a mixture of value and growth as a recognized approach, so this does not have to be an all-or-nothing commitment.

Cons

• The strategy can lag for years at a time. FINRA says sentiment on out-of-favor stocks may take years to change, and describes value and growth returns as following a cycle of strength and weakness.
• Low price and good value are not the same thing, and FINRA says so: some companies sell off because of a deterioration that is not yet widely understood.
• A mechanical screen can load a portfolio with the same kind of trouble at once, because the same conditions make many companies look cheap simultaneously.
• A concentrated version depends on a small number of individual judgments, with little else in the portfolio to absorb one of them being wrong.
• There is no official definition, so two funds using the word can screen on different measures and hold different companies.
• A broad market fund already holds these companies, so the strategy is an active decision that needs an active reason.