US Edition
Did you avail yourself of a few bottles of half-price prosecco in the supermarket before Christmas? Or have you ever bought the worst house on the best street knowing that you could renovate it to increase its value? Or bought an ex-demonstrator car at 15pc off the list price?
If the answer to any of these questions is yes, you already have a good idea of what is meant by “value investing”: buying shares in a company when those shares look cheap relative to the real value of the business.
But here’s the funny thing: many of the people who will wait until a steak is on offer at half price before they buy it will be the same people who buy stocks when they are trading at record highs.
To illustrate this, more money went into the American stock market in 2021 when it was at record levels than in the previous 19 years added together, according to Bank of America. This is because when people are buying groceries, a car or a house, they tend to act rationally and are able to make a sober assessment of the price relative to the value of what they are buying.
Unfortunately, when it comes to buying stocks we tend to become emotional and our decisions are influenced by fear and greed. When investors see stocks going up and other people getting rich (at least on paper), they have a strong urge to join the herd and rush into the market, often at completely the wrong time.
This is what produces stock market bubbles.
Conversely, when bad news is on the front pages and share prices are plummeting, investors often become fearful and sell at the worst possible time.
Value investors try to exploit this emotional behaviour in other investors by purchasing stocks when temporary bad news has pushed the share price well below the true value of the business. This is what the prominent American value investor Warren Buffett meant when he advised investors to be “fearful when others are greedy and greedy when others are fearful”.
To illustrate this point, imagine that your friend has offered to sell you her ice cream van. You turn up to discuss the price with her on a wet Wednesday in March when she has sold three ice creams in six hours. The chances are she is going to offer you a significantly better price for the business than if you met at the end of a hot day by the beach in August when she has sold out by the middle of the afternoon.
But let’s say that you intend to own this van for the next 10 years. If so, your assessment of its value should be based on the likely cash flows the business will produce during this period. Neither the slump in sales in March nor the buoyant sales of August have any real impact on the long-term value of the business yet they are likely to have an emotional impact on your friend’s ability to price the business.
If you are a value investor, you will buy the business during the March downpour rather than the summer heatwave.
Many of the most famous investors of the past 50 years have made their fortune by following a value investing strategy; Buffett, his late partner Charlie Munger and the late Sir John Templeton are synonymous with this approach.
But despite this, value investing has fallen out of favour in recent years, largely as near-zero interest rates and quantitative easing produced a bubble in the most speculative corners of the stock market where value investors were unlikely to venture.
As the price of assets such as Tesla shares and Bitcoin soared to previously unimaginable highs, funds that invested in reliable but cheap businesses lagged the returns of the wider stock market and money began to flow out of value funds and either into passive funds that tracked the wider stock market or into growth funds that had their money in high-flying technology stocks.
It was not the first time this had happened. In the late 1990s many investors abandoned value investing to chase “dotcom” stocks. This ended in disaster when the bubble burst and the next few years saw “old economy” stocks outstrip the technology and telecoms sectors.
Individual investors have one advantage over professional investors, which is the fact that they won’t sack themselves! Many professional investors are now under pressure to perform not just every year but every quarter. Failure to do this leads firstly to a loss of assets and eventually to a loss of career.
This means that they simply do not have the ability to take the kind of long-term contrarian stance that characterises the true value investor but rather have to plough into all the hot stocks that everyone else is buying.
The private investor does not face this pressure and hence, at least in theory, has the ability to take a longer-term view than most professional investors.
Encouragingly, interest in value investing does appear to have picked up recently as some believe that the conditions that drove the strong returns of growth stocks (zero interest rates and quantitative easing) have ended and that a return to more normal levels of interest rates will produce a stock market in which prices are driven more by fundamentals.
The fact that so much money has gone out of value funds and into growth funds in the past decade also means that the disparity in valuations between the two types of stock is higher than it has been for years and that there are some real bargains to be found if you know where to look for them.
Ian Lance is co-manager of Temple Bar investment trust
‘We buy the ice cream van in March, not August’: the key to being a ‘value’ investor
One value fund manager explains the strategy behind his investment approach