Value investing is one of the most well-known investing strategies and some of its most famous practitioners include Warren Buffett, Charlie Munger, Ben Graham, Seth Klarman, and Mario Gabelli. The concept is quite simple and intuitive - buy discounted assets and sell when they become fairly or fully priced. Reasons that assets become discounted vary, but some common reasons include a recession, company-specific stress, investor sentiment, or industry turmoil.
The common thread is that during these moments prices become disconnected from value. Price is a function of value, perceptions, and emotions. During these times, value investors try to be rational, while others panic. Of course, the task is complicated, because sometimes prices are lower in anticipation of value destruction. An example is coal stocks in 2011 which were cheapy by conventional financial metrics, however, they still went bankrupt due to mounting environmental regulations and cheaper natural gas.
How to Find and Define Value
Therefore, value investors also must ensure that there is some sort of enduring competitive advantage that will allow the company's business to survive until conditions improve. Companies in dying industries that look cheap on paper have trapped many value investors in history and are known as "value traps".
Value investors use a variety of tools to try to measure value. Some common ones include the price to earnings ratio, price to sales, free cash flow analysis, and the EBITDA to Enterprise Value. Different measures work better for different situations. Choosing the right one is part of the art of value investing.
The counterpart to value investing is growth investing. These investors tend to buy expensive stocks that are seeing rapid gains in sales, earnings, and share price. These investors are piling onto a trend in hopes that it will continue. Unlike cheaper value stocks where expectations are low, and there tends to be a margin of safety, growth stocks have high expectations to justify their valuations. Thus they can also see staggering losses if growth disappoints.
When Value Investing Works
Value investing works best during bear markets. Bear markets lead to panic selling out of fear, creating discounts for good businesses. In contrast, bull markets are marked by optimism, leading to richer valuations for stocks across the board and fewer opportunities for value to emerge.
