How to be a value investor: A beginner's guide

The enduring benefits of value investing over time

Value investing entails purchasing stocks that are inexpensive relative to their intrinsic value or fundamental metrics such as earnings, revenue, cash flow, or book value. These stocks typically trade at a discount due to low investor expectations or concerns about their future prospects. Investors in value stocks anticipate an improvement in fundamentals, leading to enhanced performance over time.

Research indicates that value stocks have historically outperformed the broader market over extended periods, particularly small-cap value stocks. The performance of value stocks is often influenced by early economic expansions and bull markets due to their susceptibility to bear market downturns and cyclicality, leading to earnings growth at the onset of expansions.

Renowned value investor Joel Greenblatt encapsulates the essence of value investing with his quote: "The secret to investing is to figure out the value of something – and then pay a lot less." This philosophy of value investing continues to adapt and thrive over time.

Exploring the evolution of value investing: From Graham to Buffett and beyond

Value investing has transformed over the years, initially championed by Benjamin Graham, revered as the Father of Value Investing. His seminal works like The Intelligent Investor laid the groundwork for value investing principles. Graham advocated for viewing stock ownership akin to owning a business, emphasizing the purchase of undervalued stocks with a long-term perspective and a focus on a "margin of safety."

Warren Buffett, arguably the most successful investor in history, was mentored by Graham during his time at Columbia Business School. Initially a deeply focused value investor, Buffett's strategy evolved towards acquiring high-quality businesses at discounted prices, though valuation remains integral to his approach.

Over the past century, value investing has undergone a metamorphosis, transitioning from seeking stocks trading near book value to targeting quality companies at reasonable prices. Today, the strategy encompasses identifying companies with potential for growth, even if they may not appear cheap initially—such as prominent technology firms that were considered bargains several years ago.

Regardless of its evolution, the core tenet of value investing—acquiring assets below their intrinsic value—endures as a timeless investment strategy.

Discovering inexpensive stocks through diverse value metrics

Below are some of the most common value investing metrics, along with explanations:

Price/Earnings (P/E)

This ratio compares the stock price to earnings per share, indicating whether a stock is priced cheaply relative to its earnings. A low P/E ratio suggests a potential value opportunity as earnings improve.
   P/E = Stock Price per Share / Earnings per Share

Price/Sales (P/S)

This ratio compares the stock price to sales per share, offering insight into a stock's valuation relative to its revenue. A low P/S ratio indicates an attractive value compared to peers, as sales figures are less prone to manipulation.
   P/S = Stock Price per Share / Sales per Share

Price/Book (P/B)

This ratio compares the stock price to its book value per share, assessing whether a stock is undervalued based on its assets' value on the balance sheet.
   P/B = Stock Price per Share / Book Value per Share

Price/Cash Flow (P/CF)

This ratio compares the stock price to cash flow per share, providing an alternative to earnings as a measure of a company's profitability. Cash flow is considered harder to manipulate than earnings.
   P/CF = Stock Price per Share / Cash Flow per Share

Enterprise Value/Earnings Before Interest Taxes Depreciation and Amortization (EBITDA):

This ratio evaluates a company's enterprise value relative to its EBITDA, representing its market capitalization plus debt minus cash. It offers insight into a company's value from the perspective of a potential acquirer in a private transaction.

In general, lower valuation ratios suggest that a stock offers better value, making it potentially attractive for value investors.

Why value investing proves effective

Value investing has proven its efficacy over time, but delving into the underlying reasons behind the premium associated with value stocks is essential. There are two primary explanations:

The risk-based explanation

This asserts that value stocks outperform because they carry higher risk than other stocks. Contrary to the perception of value stocks being conservative, they often represent companies facing uncertainty or decline, making them vulnerable during economic downturns. Consequently, during recessions, value stocks tend to suffer more severe setbacks. However, they often rebound strongly as economic conditions improve, indicating that value stocks might actually exhibit higher, not lower, risk.

The behavioral-based explanation

This suggests that investors tend to both underreact and overreact to news, causing fluctuations in stock prices. For value stocks, which typically involve uncertainty regarding their future prospects, this explanation posits that investors collectively become excessively pessimistic about a company's challenges, leading to an exaggerated decline in its stock valuation. As business conditions improve, even marginally, stocks tend to revert as investors realize the situation isn't as dire as previously thought.

The truth lies somewhere between these two explanations, as both risk and investor behavior play significant roles in driving the value premium. However, both perspectives offer insights into why the value investing strategy is likely to remain effective in the future.