If you’ve ever watched CNBC or read the Wall Street Journal, you’ve probably heard the term “value investing” thrown around quite a bit. And, like me, you probably assumed that it involves something along the lines of finding good stocks at cheap prices. Well, you’re right, but I think it’s important to lay it out a bit more formally. In a nutshell:
- Stocks prices are affected by many variables which cause them to fluctuate
- Human psychology (i.e., irrational behavior) is a huge driver of these fluctuations
- However, despite this, these stocks do have real underlying values
- Value investing entails buying only those stocks trading significantly below those real values
An Easy to Understand Example
For example, take the current housing situation. If you were to ask the average investor which housing stocks he would buy today, they would probably laugh and respond “I would stay away from anything having to do with housing right now”.
For the most part, they are right. But, what if you found a homebuilding stock that had a strong balance sheet, no debt, and had positioned itself to minimize risk exposure to falling property values? Further, what if that company was trading at a price per share that was lower than the per share value of its assets (if they were to be liquidated)?
A true value investor (i.e., Warren Buffett) would take a conservative approach and wait until the stock traded at a price at least 20% below what he / she thought it was worth before buying it. By doing so, they are taking advantage of irrational investor behavior, as well as the institutional “bias” toward stocks considered en vogue. In addition, they are giving themselves what Benjamin Graham dubbed a “margin of safety” which ensures solid returns.