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 clear what this means. For some it's all about buying shares on low price-to-earnings ratios (PERs); others buy tangible assets for less than their book value; still more claim that a stock like Amaysim can offer value, despite a PER of 36 and a price-to-tangible book value of 96.

What's the theory that ties up these loose ends? Now that Intelligent Investor provides share research for the Eureka Report, here's our guide to the whole caboodle.

Here, we'll look at the essence of value investing. In coming weeks, we'll expand on this to cover margin of safety, book value, PERs and all the rest of it. It should be useful background information so you can make the most of our research.

Old as the hills

The idea of value investing is as old as the hills—or at least as old as the people that have lived on their slopes. Take the ancient Yir Yoront people of the Cape York peninsula, for example. They desperately needed stone to collect firewood, make tools, build huts and climb trees to gather honey. Yet, living as they did on a flat alluvial coastline, they didn't have the materials or the know-how to make them.

The axes were made from a dense basaltic rock found close to what is now Mount Isa. Chipped easily into shape, it maintained its sharp edge well and was skilfully 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 moved 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.

Value finds its own level

The increase in the price and value of the items as they moved along the trade route reflected the effort needed to get them there. If someone decided it was worth walking the extra 50 kilometres to get an additional stingray barb in return for his surplus axe heads, that's what they did. And if someone tried to charge more for his stingray barbs than they were worth in his region, the trade found its way around him.

Value, like water, finds its own level. Sooner or later, the true value of something is 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.

As our ancient traders showed, value is not so much an investing strategy as the very force that keeps markets ticking along.

Trouble is, when the items you're trading have their price quoted by the minute, strange things happen. People start to care less about the value of the items and instead become fixated on where they think prices are headed.

If people believe prices are headed up, they pay more for something than what it's worth in the hope of passing it on to a "greater fool" at an even higher price. The Yir Yoront and the Kalkadoon would view this as a dangerous game. And so it is. As with chain letters and “Ponzi schemes”, some people will make money but eventually someone is left holding an over-priced stock with no willing buyers.

Because a stock's intrinsic value will eventually be realised, the net effect for all investors of buying stocks above their real value will be a loss. The net effect for all investors of buying stocks below their intrinsic value will be a gain. The aim of value investing is to do the latter, not the former.

We do not want to rely on the appearance of a “greater fool” to make money. Instead, we aim to buy something for much less than it's intrinsically worth and sell it at a price that reflects its true value, or higher. With the resulting profit we repeat the process.

If someone comes along soon after purchase and makes us an offer we can't refuse, great. If we have to wait a few years, that's no problem either. Time is on the value investor's side. As long as we're buying stocks for less than their real value, we'll do well. And that's the essence of value investing.