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Value Investing and Why it Works

Value Investing is a practical, proven methodology that focuses on buying investments at a price lower than their intrinsic value. This page is divided into three sections. The first describes the ideas behind Value Investing. The second describes some of the advantages of Value Investing. The third describes how we do Value Investing at Princeton Value Advisors.

You can also receive a copy of this web page as a white paper. Click here to receive your copy.

What is Value Investing?

The term "Value Investing" comes from the fact that Value Investors will buy a stock - or any investment - only when its price is lower than its value. Another way of saying the same thing is that Value Investors will purchase a stock, or any investment, only when it is "On Sale".

Value Investing uses three related ideas to improve the odds of making good investments.

  1. Every investment has an intrinsic value and if you pay more than this you convert a prudent investment into a risky one that is likely to do poorly.
  2. The intrinsic value of an investment in a company is determined by the profits of the company's business over the long term.
  3. By looking at the historical record one can, at least approximately, determine the likely profitability of a business over the long term and thus its intrinsic value.

The Advantages of Value Investing

Value Investing benefits you in two ways. First, it improves your odds of selecting good investments. Second, it enables you to avoid common investing mistakes.

Why Value Investing Increases Your Chances of Success

You can't lose buying a Value Investment!

The great thing about purchasing a stock or other investment for less than its intrinsic value is that you can't lose. Either...

  1. The investment's price will rise up to or above its intrinsic value and you can sell it at a good profit.
  2. The price will stay the same or even go down. In which case you keep the investment, or even purchase more, and then sit back and enjoy a good return on your investment from the dividends or other return (e.g. interest) that the investment pays.

Of course, successful Value Investing doesn't just happen. It depends on determining a stock's intrinsic value. Our success over the years shows that we are good at doing this.

Value Investing Gives you a Rational Standard for "When" to Buy, Sell, and Hold an Investment

Investors ask us "How do you know when to buy or sell an investment? It seems like a crapshoot." We agree that deciding "when" to buy or sell an investment is pure guess work. That is why we make our buy/sell decisions based not on when but at what price.

Once a Value Investor, like Dr. Wertz, has gone through the process of determining an investment's intrinsic value, they have a rational standard for buying or selling an investment. If it is selling below its intrinsic value it is rational to purchase it. If it is selling above its intrinsic value you should probably sell it. If is selling near or below its intrinsic value and you already own it, you should hold it. It is that simple.

With this buy/sell discipline we are able to confidently buy stocks during the financial crisis and other bear markets when they are cheap and sell them in bull markets when they are expensive. Our ability to do this has played a big part in our investment success.

Value Investing Focus's Your Attention of What Ultimately Determines the Value of a Stock

As discussed below in more detail, financial theory says that over the long term the value of a company's stock is determined by the profitability of the business that the company operates. To be more specific, it is not the profits per se but the dividends derived from those profits. This is backed up by history. Over the last 100 years 80% of the return from stocks has come from the dividends paid and almost all of the rest has come from companies increasing their dividends. Currently the average stock's dividend yield is below 2% per year, way below the historical average of 4.5%. At a 2% yield you have to hold the stock 50 years to just to get your money back. To make a profit will take longer. This is a ridiculously long time.

Two things about this situation are clear:

  1. Dividends are currently much too low -- as a result of stock prices being too high.
  2. To rationally buy a stock as an investment instead of a "short term buy and sell speculation" you have to concerned with what is likely to happen over the next 20+ years, not just the next 2 or 3.

Common Errors Avoided by Value Investing

Straight-line Extrapolating the Past into the Future

Extrapolating is very useful in day-to-day life. For example, if someone throws a baseball in your direction it isn't going to change direction and go somewhere else but will continue in your direction. Unfortunately, both the stock market and a company's business performance don't move in a straight line, even approximately. Instead they oscillate, with a period of moving up followed by a period of moving down. Given these oscillations, trying to predict stock prices by extrapolating the past into the future is doomed to failure. Studies have shown that investors' tendency to extrapolate the past into the future causes them buy stocks when the market has been going up and the prices of stocks are high -- and then selling them when the market is falling and prices are low. This "buy high" and "sell low" behavior results in poor returns and even outright losses.

Growth Stock Investing

The underlying assumption of growth stock investing is that the price of a company's stock will grow if its business is growing. After all, a company with larger profits is worth more than a company with lower profits. Given this fact, how can the stock of a growing company not be worth more in the future than it is now? The answer: Many people have noticed that the company was growing and bid up the price of the stock. You will lose money if you pay more for the stock today than the company's future growth is worth. History shows that investors as a group almost always pay too much for a company's future growth because they extrapolate today's growth into the indefinite future. The reality is that companies do not grow rapidly indefinitely. Instead, after a few years their growth stagnates or even declines. Technology companies in particular have a tendency to be rockets that fail to make it into orbit. They shoot up rapidly and then fall just as rapidly back to earth.

Buying an Investment Only Because It Will Go Up in PRICE

All of the previous investment errors are the indirect result of believing in this one bad idea. Why, you might ask is buying stock that will go up in price such a bad idea? It is a bad idea because there are only two reasons for a stock or any investment to go up in price.

  1. It is selling for less than its intrinsic value. In this case it is a Value Investment and, as discussed above, it is a good purchase even if it doesn't go up in price.
  2. It is selling for more than its intrinsic value so the reason it is selling at its current price is that people have become irrationally enthusiastic about it. The only way its price will go up is if people get even more irrational about it. If you have the ability to predict how irrational people will become then, by all means, peruse this strategy. We stay away.

Buying a stock or any investment only because you believe it will go in price is also known as the "Greater Fool Theory of Investing". Loosely translated: You know that only a fool would buy the "investment" at its current price but you are confident that you can sell it later to an even greater fool. Unfortunately, all too often you, not someone else, turns out to be the greater fool.

Value Investing at Princeton Value Advisors

Determining Intrinsic Value

All Value Investors base their decisions on the idea that an investment has an intrinsic value and that successful investing requires one to buy investments at or below this price. However, they do differ in how they determine this intrinsic value. Our investment decisions are based on the following approach to determine an investment's intrinsic value.

  • The Intrinsic Value equation (see below) converts any future performance of a company's business into a value at which it is rational to purchase the company.
  • While it is impossible to reliably predict how a company's business will do in the future, it is possible, by looking at the historical record of how other business have performed over the long term, to determine a range in which the business is likely to perform. Then, using the Intrinsic Value equation one can convert this range of business performances into a range of reasonable prices for the company.
  • An investment in a company is likely to do well if you buy it the at low end of this reasonable range or, even better, well below the reasonable range.

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In this equation r stands for the minimum return that you require to invest in risky stocks instead of, for example, safe government bonds. The numbers 1, 2, etc. stand for years 1, 2,...

For the sake of completeness, we should point out that the Intrinsic Value equation is taught in every serious course on investing where it is usually called the Present Value equation because it can be used to evaluate the maximum price that you should pay today for any investment that returns one or more payments in the future.

Let draw your attention to two important things about the Intrinsic Value equation.

  1. The price at which you can sell the stock in the future doesn't appear, only the dividends that the company pays. This means that one is dependent on dividends not only for the profit on your investment but to also get back the capital that you invested in the first place.
  2. One of the truisms of investing is that one dos not have a return ON investment (i.e. a profit) until you have gotten the return OF your investment. The current yield on the S&P 500 is below 2%. At this rate it will take 50 years to recover your investment. Getting a profit will take longer. About half of companies in the world die before they are 50 years old.

In summary Value Investing and the intrinsic value equation that lies behind it forces you to focus on the profitability of a company's business over the very long term and ignore what the stock's price is likely to do.

All Predictions are Risky, Especially Those about the Future

The heart of our approach is to use the historical record of how other businesses have preformed to identify the likely range of business performances of the company we are looking at. Then we use the Intrinsic Value equation to convert this into a range of reasonable prices to pay for the company's stock. Finally, we will buy the company only if its current price is at the low end of this range. Unfortunately, the range of possible performances of a business is quite wide. In particular, history says that no matter how well a business is doing today that bankruptcy is a very real possibility when one looks out 10, 20, or 30 years into the future. We deal with this problem in several ways.

  • We Diversify. We put only a small percentage of an account in any one investment. That way even if our predictions about a company are very wrong the damage done to the account as a whole is small.
  • We are conservative, even pessimistic in our predictions. Unless there is strong evidence to the contrary, we assume that if a business has been doing much better than the average that its profits will trend downward over time and that eventually its profits will decline to average, and then to below average. If the company is in a cyclical business we assume that in some years profits will be poor. If the company's business is an average performer now we assume that it will be a below average performer in the future. The father of value investing, Benjamin Graham, called taking these precautions having a "margin of safety".
  • A Company Must be Able to Survive Bad Times, Since it takes 20+ years to get your investment back from dividends it is important that a company survive that long. One of the ways that a company can increase the profits to which each share of its stock is entitled is to borrow a lot of money. When times are good having the company borrow money increases the return received by shareholders. However, when times are bad interest payments on the borrowed money will cause the company to lose money. Loans are made for a specific period of time, after which the money has to be paid back. If a company has borrowed a lot of money and it starts losing money there is a substantial risk that it can't pay back its loans when they become due. When this happens the company will file for bankruptcy and the shareholders lose everything they have invested in the company. While we do on occasion invest in companies with a lot of debt, we will do so only if it is selling at a steep discount to what a similar company without debt would sell for.

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