The term 'Value Investing' is included in the Economics edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Value investing is the strategy that Benjamin Graham developed for investing in stocks. Warren Buffet later made it famous after he left Graham’s company and went on to found Berkshire Hathaway. Buying stocks this way involved a level of discipline practiced by insurance underwriters. The method focuses on several key ideas. Investors have to consider risks involved carefully, avoid stocks which show a high amount of uncertainty, and allow a margin of safety.
Graham developed his different investing techniques while managing money as President of his Graham-Newman Corporation. He focused on net working capital investments, arbitrage, diversification, and tangible assets. Investors continue to use all of these but the first one over seventy years later.
Net working capital originally functioned as a cornerstone of value investing until changes in transparency rules and market technology made it obsolete. Net working capital investments were those where the stock’s shares traded at a large 30% or higher discount to their amount of working capital.
The idea was that a value investor could buy dollar investments for effectively 70 cents or less. Some of these companies failed. This was mitigated by diversifying into many different stocks. On a combined basis, these companies brought Graham and his investors good returns. Warren Buffet utilized this category of investments heavily in his early years running the Buffet Partnership that eventually became Berkshire Hathaway.
Arbitrage proved to be the value investors’ secret weapon. Graham passionately believed arbitrage would routinely provide 20% annual returns. This boosted the total return on the overall value investing portfolio. Arbitrage seeks to make money on discrepancies in price with little or even no risk.
If a company makes an offer for a rival at $60 per share, but the shares trade at $57, there is a $3 price discrepancy between that point and when the deal closes. This amounts to possibly 5% that investors can acquire in a matter of a few months. Assuming the deal closes, there is no risk in this trade. Value investors simply use arbitrage as a way to profit from a security and the money time value that is literally undervalued.
Diversification remains a critical component of Graham’s investing strategy. He believed in diversifying into as many individual investments as made sense. He also practiced diversification into different kinds of asset classes. Value investing puts a certain percentage into common stocks, preferred stocks, mutual funds (which did not yet exist when Graham created the strategy), and bonds. This went along with the main premise that first investors must avoid losing their money. Receiving a good return on investment money is secondary to this idea.
Tangible assets is another value investing principle that still holds today. Graham was interested in the actual physical assets that lay behind his common or preferred stocks and bonds. This might include factories, office buildings, equipment, real estate, or rail cars. He would only buy into companies whose assets were great enough to fully back up the principle and dividend or interest payments. They would have to liquidate these assets to get back their investment money. Graham told those who valued invested to constantly look at the bonds they held and be prepared to change to other bonds if they had stronger assets.
Benjamin Graham and value investing also proved to be among the earliest groups to practice tactical asset allocation. If investors studied and determined stocks were overvalued, they should sell stocks and move money into bonds. When stocks were undervalued, he counseled investors to sell bonds and go heavier into stocks. This is still a cornerstone idea of investing today.