Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. Modern value investing derives from the investment philosophy taught by Benjamin Graham and David Dodd at Columbia Business School starting in 1928 and subsequently developed in their 1934 text Security Analysis.
The early value opportunities identified by Graham and Dodd included stock in public companies trading at discounts to book value or tangible book value, those with high dividend yields and those having low price-to-earning multiples or low price-to-book ratios.
Proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". Buffett further expanded the value investing concept with a focus on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price. Hedge fund manager Seth Klarman has described value investing as rooted in a rejection of the efficient-market hypothesis (EMH). While the EMH proposes that securities are accurately priced based on all available data, value investing proposes that some equities are not accurately priced.
Graham himself did not use the phrase value investing. The term was coined later to help describe his ideas. The term has also led to misinterpretation of his principles - most notably the notion that Graham simply recommended cheap stocks.
History Early predecessors The concept of intrinsic value for equities was recognized as early as the 1600s, as was the idea that paying substantially above intrinsic value was likely to be a poor long-term investment. Daniel Defoe observed in the 1690s how stock for the East India Company was trading at what he believed was an elevated price of over 300% more than face value, "without any material difference in Intrinsick [sic] value."
Hetty Green (1834-1916) was retrospectively described as "America's first value investor." She had a habit of buying unwanted assets at low prices, which she held, as she stated in 1905, "until they go up [in price] and people are anxious to buy."Higgins, Mark. "The Story of Hetty Green: America's First Value Investor and Financial Grandmaster." Financial History. Museum of American Finance. (Fall 2022). link here
The investing firm Tweedy, Browne was founded in 1920 and has been described as "the oldest value investing firm on Wall Street".Charles B. Carlson (2010). The Little Book of Big Dividends. NY: John Wiley & Sons, ISBN 978-0-470-56799-9 Founder Forest Berwind "Bill" Tweedy initially focused on shares of smaller companies, often family owned, which traded in lower numbers and lower volume than stock for larger companies. This niche allowed Tweedy to buy stocks at a significant discount to estimated book value due to the limited options for sellers.Eli Rabinowich (February 12, 2004).Profiles in Investing: A Legacy of Value (interview with Christopher H. Browne, from the Graham & Doddsville Newsletter published by Columbia Business School) Tweedy and Benjamin Graham eventually became friends and worked out of the same New York City office building at 52 broadway.
Economist John Maynard Keynes is also recognized as an early value investor. While managing the endowment of King's College, Cambridge starting in the 1920s, Keynes first attempted a stock trading strategy based on market timing. When this method was unsuccessful, he turned to a strategy similar to value investing. In 2017, Joel Tillinghast of Fidelity Investments wrote: Instead of using big-picture economics, Keynes increasingly focused on a small number of companies that he knew very well. Rather than chasing momentum, he bought undervalued stocks with generous dividends. [...] Most were small and midsize companies in dull or out of favor industries, such as mining and autos in the midst of the Great Depression. Despite his rough start [by timing markets], Keynes beat the market averages by 6 percent a year over more than two decades.Joel Tillinghast (2017). Big Money Thinks Small: Biases, Blind Spots and Smarter Investing. Columbia University Press,
Keynes used similar terms and concepts as Graham and Dodd (e.g. an emphasis on the intrinsic value of equities). A review of his archives at King's College found no evidence of contact between Keynes and his American counterparts and Keynes is believed to have developed his investing theories independently. Keynes did not teach his concepts in classes or seminars, unlike Graham and Dodd, and details of his investing theories became widely known only decades after his death in 1946.Chambers, David and Dimson, Elroy, John Maynard Keynes, Investment Innovator (June 30, 2013). Journal of Economic Perspectives, 2013, Vol 27, No 3, pages 1–18, Available at SSRN: https://ssrn.com/abstract=2287262 or http://dx.doi.org/10.2139/ssrn.2287262 There was "considerable overlap" of Keynes's ideas with those of Graham and Dodd, though their ideas were not entirely congruent.J. E. Woods, On Keynes as an investor, Cambridge Journal of Economics, Volume 37, Issue 2, March 2013, Pages 423–442, https://doi.org/10.1093/cje/bes061
Benjamin Graham
Value investing was established by Benjamin Graham and David Dodd. Both were professors at Columbia Business School. In Graham's book The Intelligent Investor, he advocated the concept of margin of safety. The concept was introduced in the book Security Analysis which he co-authored with David Dodd in 1934 and calls for an approach to investing that is focused on purchasing equities at prices less than their intrinsic values. In terms of picking or screening stocks, he recommended purchasing firms which have steady profits, are trading at low prices to book value, have low price-to-earnings (P/E) ratios and which have relatively low debt.
Further evolution The concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF), where the value of an asset is the sum of its future cash flows, discounted back to the present.
Quantitative value investing Quantitative value investing, also known as Systematic value investing,Wesley R. Gray, Phd. and Tobias E. Carlisle, LLB. Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. Wiley Finance. 2013 is a form of value investing that analyzes fundamental data such as financial statement line items, economic data, and unstructured data in a rigorous and systematic manner. Practitioners often employ quantitative applications such as statistical / empirical finance or mathematical finance, behavioral finance, natural language processing, and machine learning.
Quantitative investment analysis can trace its origin back to Security Analysis by Benjamin Graham and David Dodd in which the authors advocated detailed analysis of objective financial metrics of specific stocks. Quantitative investing replaces much of the ad-hoc financial analysis used by human fundamental investment analysts with a systematic framework designed and programmed by a person but largely executed by a computer in order to avoid cognitive biases that lead to inferior investment decisions. , The Psychology of Human Misjudgement a speech by Charlie Munger In an interview, Benjamin Graham admitted that even by that time ad-hoc detailed financial analysis of single stocks was unlikely to produce good risk-adjusted returns. Instead, he advocated a rules-based approach focused on constructing a coherent portfolio based on a relatively limited set of objective fundamental financial factors.
Joel Greenblatt's magic formula investing is a simple illustration of a quantitative value investing strategy. Many modern practitioners employ more sophisticated forms of quantitative analysis and evaluate numerous financial metrics, as opposed to just two as in the "magic formula".Joel Greenblatt. The Little Book That Still Beats the Market. Wiley. 2010 James O'Shaughnessy's What Works on Wall Street is a classic guide to quantitative value investing, containing backtesting performance data of various quantitative value strategies and value factors based on Compustat data from January 1927 until December 2009.James O'Shaughnessy. What Works on Wall Street Fourth Edition. McGraw Hill. 2014
Value investing performance
Performance of value strategies Value investing has proven to be a successful investment strategy. There are several ways to evaluate the success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole, not necessarily over short periods but when tracked over long periods, even going back to the 19th century. A review of 26 years of data (1990 to 2015) from US markets found that the over-performance of value investing was more pronounced in stocks for smaller and mid-size companies than for larger companies and recommended a "value tilt" with greater emphasis on value than growth investing in personal portfolios.Craig L. Israelsen (2011, updated 2016) Comparing the results of value and growth stock market indexes excerpted from Israelsen's 7Twelve: A Diversified Investment Portfolio with a Plan (John Wiley & Sons Inc.), ; Fidelity.com, accessed 07 Feb 2020
Performance of value investors Since examining only the performance of the best known value investors introduces a selection bias (as typically investors might not become well known unless they are successful) a way to investigate the performance of a group of value investors was suggested by Warren Buffett in his 1984 speech The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were influenced by Benjamin Graham. Buffett's conclusion was that value investing is on average successful in the long run. This was also the conclusion of the academic research on simple value investing strategies.
From 1965 to 1990 there was little published research and articles in leading journals on value investing.Joseph Nocera, The Heresy That Made Them Rich, The New York Times, October 29, 2005
Well-known value investors The Graham-and-Dodd Disciples Ben Graham's students