Value investing is a philosophy that disregards the efficient market hypothesis and instead, seeks to identify undervalued buying opportunities. The central idea behind this approach is that every company has an inherent intrinsic value that is often mispriced by the market. A value investor has one primary objective, to identify stocks that are priced lower than their actual worth. Therefore, the term “value” is used to signify the aim of getting more returns for each dollar invested.

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What is a Value Investor?

Value investors focus primarily on the price they pay for a business. A value investment strategy is based on the belief that every company has an associated value, and by understanding that value, they can buy when the business is undervalued and get more for their money. It is like waiting for groceries to go on sale, buying more for less. Investors can take advantage of the market when companies are offered at discounted prices, much like waiting for a sale at a retailer.

‘Value’ never dies. Never. Price is what you pay, value is what you get.

David Rolfe

Value investors go against the herd by adopting an investment philosophy that focuses on identifying securities that are underpriced based on fundamental analysis. By recognizing stocks that are not reflecting their intrinsic value, investors can profit by closing the gap between price and value.

The ultimate goal of a value investor is for the market to recognize the true value of the company over time, bringing the valuation back to its fair price. The value investing strategy is contrarian because investors often purchase out-of-favour companies that the herd has missed. Investors believe that because of irrational behaviour and “Mr. Market,” certain assets are ignored, and there is greater value than the market can see. Value investors are always on the lookout for companies they believe the market has undervalued.

Value Investing has largely been attributed to Ben Graham who followed a very strict Quantitative Analysis process. He focused on the fundamentals and purchased securities often with no regard for what the business did. It was purely based on how much of a bargain the company was trading for. The bargains often reflected low multiples like price-to-book, and price-to-earnings and traded at a discount-to-book value.

How does Value investing work?

The belief that a stock is undervalued is purely presumptive and based on your analysis of why you think it is trading at a discount. Value investing is a lot like investigative journalism that follows a strict investment process. Value Investors need to study the fundamentals of the business and determine why it is undervalued and why the market has underestimated it.

Once you identify the intrinsic value of a stock, you often buy it with a margin of safety. This means you leave a gap between the intrinsic value and your buy price to allow for a margin of error. Having a margin of safety can help limit downside risk should your initial valuation not play out.

Let’s take an example to explain how value investing works. A company’s stock price fluctuates due to several factors, such as market cycles, industries falling out of favour, or investors irrationally moving against a company. As a value investor, the goal is to identify a business that appears to be a bargain based on several factors, however usually low multiples.

You will then conduct fundamental analysis and valuation work, such as a DCF model or multiples valuation, to estimate the intrinsic value. You will wait for the price to drop further or for there to be a large enough distance between your estimated valuation and where the stock price sits, leaving you a margin of safety.

Once you buy, you then monitor, and wait patiently for the thesis to play out. You hope the market will catch on and identify the stock’s true value, bringing the stock price back to fair value, so you can offload it.

Why do Stocks become undervalued?

Stocks can become undervalued due to various reasons. Generally, undervalued companies are associated with negativity, which causes them to lose favour. To identify a value play, value investors must filter out the noise and distill the information down to facts. A logical approach combined with sound fundamental analysis can help investors determine whether a company presents a good investment opportunity.

Undervalued companies tend to operate in mature industries, producing widely used goods and services. These companies have been operating for years, providing a lot of historical data points for reference. Value investors focus on well-established companies, delivering stable revenues, and consistent profits. They are typically (not always) found around the following Business Life Cycle – Maturing or Declining.

The following are some of the reasons why companies become undervalued:

• Temporary issues with the business, fuelled by negative financial media headlines.
• Analysts downrating which impacts short-term pricing.
• Unexpected financial results and missed earnings calls.
• Shift in management, departure of longstanding board, CEO, Founder.
• Cyclical fluctuations, perhaps commodity business in a downcycle.
• Industry trends that shift focus away from a particular sector.
• Market sentiment, herd mentality, one sells they all run for the hills.
• Diversification away from core business and it failed.
• Overseas expansion into new markets that is in early stages.
• Bear markets punishing ALL stocks even the good quality ones.

Small-Caps can remain undervalued for years, primarily due to lack of liquidity, limited awareness about the company, inability to raise capital, and the company still being in an early growth stage. I have seen many “Growth” small-caps with great fundamentals, healthy balance sheets, and no debt drop to single-digit price-to-earnings for no other reason than investors looking for safer options.

What are the pros and cons of being a Value Investor?

There are a few considerations before looking to implement this successful investing style into your philosophy and strategy. I have listed a few pros and cons to think about. Reflect on each one to help form your own belief and opinion about value investing.

➕ Pros	➖ Cons
Profit!!! Value investing when practiced prudently can generate fantastic profits.	Undervalued companies are hard to find. They require a lot of ground work and “turning over rocks”.
Over time Value Investing provides a great way to beat the markets.	It is easy to fall into a Value trap, a company posing as a bargain, that often deserves it and does not “revert to the mean”.
Often investing into blue chip companies, that are well established and usually pay dividends. (Being paid to wait).	Requires a lot of patience, a lot of holding, waiting for the market to see that you were right. Underperform for long durations.
If you buy right with a margin of safety it is a relatively low risk to reward payoff.	Discipline and methodical investing process, based on valuation, and deep research.
Compounding in undervalued companies is a great wealth builder. Reinvesting dividends and allowing the company to move to fair value.	Needs an understanding of fundamental and quantitative analysis to be able to estimate intrinsic value.
Shorter time frames if you buy and sell at fair value. Which can be a positive for those not wanting to hold 10+ years.	Going against the herd, you want to have conviction in your confidence to see value where others don’t.
Having a margin of safety is a great way to limit downside risk.	Handle your emotions and behaviour. Especially if undervalued companies are the result of bear markets.

How to consider the value investor approach in your Philosophy?

To be a value investor, you need to have a strong handle on your emotions, be patient, be disciplined, and engage in a lot of second-level thinking. Adopting a contrarian approach implies that you see value where other investors don’t. As a value investor, you must have a deep understanding of fundamental analysis to identify the intrinsic value of a stock.

Value investing is a method that should be adapted based on your circumstances and your beliefs around markets, considering that no investing style is perfect. To be a successful value investor, you need to incorporate a value mindset and the confidence to avoid value traps. Conducting deep financial analysis, going against the majority, and having a stoic-like mindset are the key components of value investing.

Some of the greatest value investors could be classified as stoic investors. They took large positions when others were running and had the courage to hold until value was realized based on logical and sound fundamentals.

If you align with the philosophy of inefficient markets causing mispricing of good quality companies, and you have the conviction to patiently wait for the correction, then value investing may be for you. However, value investing is not just about numbers, analysis, and excel templates. You need to cultivate a mindset that can explain why you think this course will be corrected.

To achieve this, you must ask yourself questions such as why you think other investors are underestimating this company, and why you believe this business is not a value trap. Merely citing a low price-to-earnings ratio is not a valid reason. You need to be able to explain how you see this business playing out and being recognized for its true worth.

What are the Characteristics of undervalued stocks?

In order to become a value investor, you need to know how to find stocks that are undervalued and recognize the traits that they may possess. You must conduct fundamental analysis and thorough research on each potential opportunity to avoid falling into value traps.

Undervalued stocks can be identified by certain characteristics, including:

• Trading below its intrinsic value.
• Insiders buying, indicating that they are taking advantage of undervalued stocks.
• A significant decline in share prices.
• Negative sentiment around the company, such as bad PR, missed earnings, or poor results.
• Slow earnings growth.
• A high dividend yield, represents a strong payout that is high due to a fallen share price.
• Low price-to-earnings ratio, not related to profitability.
• P/E below the historical average that the company has traded at.
• A low price-to-book ratio and trades below tangible assets.
• Little to no debt.
• Undervalued stocks usually remain around their 52-week lows.
• Trades well below enterprise value compared to peers or the industry.

What do I think about Value investing?

Although I mainly focus on Growth at Reasonable Prices (GARP), I still take advantage of undervalued opportunities when I come across them. After all, the goal is to make money, not to be stuck in a specific investing style. Being flexible is key to successful long-term investing. This is how I think about Valuation best illustrated by the Investment Style spectrum. While I spend more time in the right upper quadrant, companies I either hold or am researching float around “Relative Value” areas.

Recently, I was monitoring a SaaS company that had historically traded at high multiples by growth standards. I watched it closely for months, becoming very familiar with the company. As a result of the tech crash and some negative news about challenges in a certain regional expansion, the company’s stock took a hit and fell from $164 a share to around $70 a share.

It seemed like the perfect opportunity, a once high-flying growth stock now a bargain. I went to work fast. The company was financially solid with a very sticky customer base, high customer retention, and what I believed to be a significant overreaction causing the large sell-off. Having also noted a fund that had a position fell into financial trouble and offloaded its entire position to access cash, which made it even more appealing.

I started accumulating at $88 a share and sold my entire position six months later at $127.50 a share. I saw an undervalued opportunity; had conviction it was mostly caused by an overreaction and was prepared to hold the quality company for years. However, after a 44% gain, I chose to allocate my funds to other ideas.

In Summary…

Value investing is a proven strategy. However, it goes against our natural human tendencies. It can be difficult to think and act with a value mindset because it requires extensive research and estimation of intrinsic value.

In bull markets or less volatile times, it can be challenging to find undervalued opportunities, as market euphoria is high. Undervalued opportunities typically arise in bear markets when there is a lot of noise and fear.

If you are drawn to this investment style and philosophy, then allow it to shape your strategy and investment process. It is crucial to have a belief around markets to give your process direction. Without aligning with a certain idea and philosophy, the stock market becomes too big of a place to “Wing it”.