The essence of value investing

The word value comes in for a lot of abuse these days. You’ll often hear that ‘so and so is a value investor’ or that ‘such and such is a value share’, but it’s not always very clear what these things actually mean. For some it’s all about buying shares on low PERs; for others it’s about buying tangible assets for less than their book value; while still others claim that a stock like Cochlear can offer value, despite a PER of 36 and a price to tangible book value of 9.

So what’s the theory that can tie up all these loose ends? As Australia’s leading value investing publication, we’ve decided to offer up a guide to the whole caboodle. In this issue we’re kicking off with a look at the essence of value investing. In coming weeks, we’ll expand on this to tie in PERs, book value, margin of safety and all the rest of it.

Old as the hills

The idea of value investing is, in fact, as old as the hills—or at least it’s as old as the people that have lived on their slopes. Take the ancient Yir Yoront people of the Cape York peninsular for example. They desperately needed stone axes for a whole range of daily activities: collecting firewood, making tools, building huts and climbing trees to gather honey (for an idea of how this might work, head along to the woodchop arena at Sydney’s Royal Easter Show). Yet, living as they did on a flat alluvial coastline, they didn’t have the materials or the know-how to make these vital tools.

In fact, the axes were made from a dense basaltic rock found close to what is now Mount Isa. This rock could be chipped easily into shape, but it maintained its sharp edge well, and it was skillfully crafted into axe heads by the Kalkadoon people. But the Kalkadoon lacked the stingray barbs they needed to make their preferred style of spear—which was excellent news for the Yir Yoront who lived and breathed stingray barbs.

So the stingray barbs flowed down a trade route from the north, in exchange for the stone axe heads that flowed along in the other direction. As the items got further from their source, their value increased.

A Yir Yoront would perhaps have given a dozen stingray barbs to secure one axe head, while a Kalkadoon tribesman might have offered a dozen axe heads for one stingray barb. Somewhere between the two, you might have found someone exchanging seven axe heads for five stingray barbs, in the knowledge that he could keep one barb and swap the other four for eight stone axes on the other side of his territory (keeping one and leaving seven to sell).

Value finds its own level

The increase in the price and value of the items as they moved along the trade route was a reflection of the effort needed to get them there. Everyone in the chain added enough labour capital (either producing goods or transporting them) to secure the items that they needed. If someone decided it was worth walking the extra 50 kilometres to get an additional stingray barb in return for his surplus axe heads, then he might do just that. And if someone tried to charge more for his stingray barbs than they were worth in his region, then the trade route would soon find its way around him.

Value, like water, finds its own level. Sooner or later, the true value of something—in terms of what it can do for people—will be recognised. And that’s the essence of value investing: you aim to buy something for less than it’s worth, so that you can keep a portion of that value for yourself when it comes to be realised. Indeed, as our ancient traders showed, value is not so much an investing strategy as the very force that keeps markets ticking along.

But when the items you’re trading have their price quoted minute by minute throughout the working day, something strange seems to happen. People start to care less about the value of the items themselves and become fixated instead on where they think their prices are headed.

At a basic level, that might be a matter of imagining that a stock price seems to be moving in a particular direction and that it might continue that way. At a more complex level, any number of arguments might be advanced to divine a stock’s next movement—maybe ‘interest rate concerns are expected to weigh heavily on housebuilders’ or perhaps ‘continued strong demand from China will maintain positive sentiment towards mining stocks’.

Greater fool

This kind of speculation, where you might willingly pay more for a stock than it’s actually worth, in the hope of passing it on to a ‘greater fool’ at an even higher price, would have struck the Yir Yoront and the Kalkadoon as a very dangerous game to play. It also strikes us as a dangerous game to play. It’s rather like chain letters and ‘ponzi schemes’: some people will make money along the way, but sooner or later most will find that there isn’t in fact a greater fool after all. And because a stock’s intrinsic value will ultimately be realised, the net effect for all investors of buying stocks above their intrinsic value will be a loss, while the net effect for all investors of buying stocks below their intrinsic value will be a gain.

So the aim of value investing is to make sure you buy things for less than they’re worth. That way, you don’t have to rely on an accommodating ‘greater fool’ appearing on cue. Of course, if you’re able to buy something for much less than it’s intrinsically worth, then you might find that you can later sell it to someone else for only a little less than it’s intrinsically worth. And you might then find that you can employ the resulting capital by buying something else again for much less than it’s intrinsically worth.

In this way a skilled value investor can make profits more quickly than by simply waiting for his investments to deliver up their value. But the crucial point is that time is on the value investor’s side: maybe someone will come along next year and make us an offer we can’t refuse for our investments, but maybe they won’t.

Next issue, we’ll take a look at what value means where stocks are concerned—what they’re actually worth to their owners.