Value investing refers to buying a stock for a price below its long term value.
The question arises, naturally, how do you determine value....what is value?
In an auction, and buying a stock is buying at an auction, the bidder determines that the item they are bidding for is worth more to them than the cash they are paying for it. In truth, this happens throughout life where there is a free market in goods. The newspaper stand operator values more the money you are giving him for the newspaper than s/he values the newspaper that they are giving you. You value the newspaper as being more than the few coins that you are giving them...thus a trade takes place. A trade will only take place if the seems to give value to both sides.
You may have been mistaken in the value you placed on the newspaper.....because there is nothing in it but old news that you picked up off the internet that morning. Or, because the vendor had fraudulently sold you last week's newspaper under the pretence that it is today's. On the other hand, you might have deliberately given the vendor counterfeit coins in exchange for the newspaper and so the vendor has not benefited from the trade If value is not increased on both sides, the reason comes down to undue expectations or fraud/coercion. Fraud is something that somebody else does to you and you can get a legal redress against it. Undue expectations is an outcome of your judgement and so is your fault (often the vendor will replace something for the goodwill that it engenders). Hence the Latin phrase “caveat emptor” i.e. buyer beware.
Money does not have to be involved in the trade, for example, if two children swap football cards or CDs or toys, then value has increased because each would not have traded unless they got something better for the thing they were giving away....and so the world is a better place as two people have been made happier, if only for a short time. In a non-free market, only one side benefits from the exchange; so, when the Mafia demand protection money only they benefit because if you had needed protection then you would already have bought it. So, they are providing you with a service that you do not need and are charging you for it. This probably will leave the world worse off; as your resentment will most likely be much more than the benefit gained by the Mafia from your “contribution”.
Different people place different values on things: value, like beauty, is in the eye of the beholder. In investing, what we are swapping for a stock is money and what we hope to get back is money. On the face of it, this simplifies things immensely. It ties us to numbers and gets us away from the subjective element of trading...or so it seems. It gives a straight up price – take it leave it. However, life is not that simple. A share price embodies two elements: value and sentiment.
The value relates to what the discounted value of all future cash flows is reasonably worth and the sentiment embodies the range of assumptions and opinions that people have about the stock. This shows up well in the case of shorting stocks (i.e. selling stocks you do not own in the hope of buying them back at a cheaper price in the future). A stock may clearly have no value, because its one factory burned down, say, and it will not be able to produce for a couple of years and hence have no way of paying off its debts and so likely to go bankrupt. The reasonable value for such a stock is zero...and yet people may hope/believe/expect that management will somehow pull the whole thing out of the fire and may be prepared to bet on that prospect. Hence the share price will be greater than zero.
So, as value investors, we need to be able to sift out the sentiment from the reasonable value. The best place to look for misplaced value is in good quality companies with good long term businesses where negative sentiment (for whatever reason) is adversely affecting the share price at the moment. During the dot.com bubble, many stocks had little intrinsic value but had a very high sentiment component in the share price, what we are looking for is the exact opposite of these companies. In the dot.com companies, the sentiment factor was based on an erroneous view of the future....in truth an unrealistic view of the future....hence the boom and hence the bust.
Value – more
So, if value is in the eye of the beholder, why would somebody value a diamond (which is not necessary for life) higher than water (which is crucial to life).
There are a number of reasons that one might value a diamond higher than water....not all of them might be logical...but that is the nature of the beast i.e. human beings. If a person is dying of thirst in the desert, they will most certainly (though, maybe, not always) value water as more valuable than a diamond...and would be prepared to trade the diamond for water. This is because in a situation where you have no water, then water is indeed the most important thing. If you are living at the side of a very clean river with as much food as you need, then you may well value a diamond as more valuable than water, for you have all the water that you need and more. Hence, the difference relates to how much you have of a product.
However, the more you have of something, the less you value it. If your husband knows that you would love a certain pair of diamond earrings for your birthday; and, if he gets them for you, you will be very happy. But suppose your daughter turns up with the exact same pair, you joy will not be as great as when you received the first pair. Now suppose your sister turns up with the same pair again and so forth for all your family. By the time you have reached the 5th or 6th pair, you will have no satisfaction whatsoever in receiving the earrings....despite how you coveted them when you did not have any. So, value is function of how many you have already. They say that the second billion dollars is not as enjoyable as the first.....I would like to test that theory.
Value Investing - what are we looking for?
There is only one important equation in investing: what you get back for what you put in. In investing we are looking at investing cash and we are looking at getting a cash return on our investment. So, when looking for companies to invest in we are not looking at profit. That statement will come as a shock to some people I am sure. But the truth of the matter is that profit is subjective, many different assumptions go into determining what is profit, and two reasonable people may well disagree within a wide margin as what the profit of a company is. The same is not true about cash. you can count how much cash goes out and you can count how much cash comes in...there is no debate. One way of looking at it is that profit is vanity and cash is sanity. Sure, in determining cashflow of a company some judgment calls are also made, but these calls are much less contentious that the ones associated with profit.
We are looking for companies which can give strong and continuous cash flow over the long term. But there is another requirement, the company should not need to invest too much to get these strong cash flows. Suppose a company needs to reinvest back in the business every dollar that it generates in cashflow, then we have a company which is capable of giving very little return to the shareholder.