What, you might ask, is "strategic" value investing? According to the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors," it is this: "... Being thoughtful about the characteristics of a particular security rather than blindly applying some sort of trading or classification rule. If we are successful in adding a strategic element to our investing, then we can expect risk-adjusted performance to improve further."
This 2014 book was written by Stephen Horan, CFA; Robert R. Johnson, CFA; and Thomas Robinson, CFA. Lead author Horan is the managing director of credentialing at the CFA Institute; Johnson is a professor of finance at Creighton University's Heider College of Business; and Thomas Robinson is president and CEO of AACSB International (the Association to Advance Collegiate Schools of Business). Johnson and Robinson were formerly with the CFA Institute.
In the Introduction, the authors took steps to define value investing, delineating what it does and does not include. At the same time, they reasoned that value investing, like beauty, is in the eye of the beholder. Benjamin Graham, Warren Buffett (Trades, Portfolio), Wally Weitz and Seth Klarman (Trades, Portfolio) may all be value investors, but each has his own particular approach.
What do they have in common? The authors responded:
"Value investing may involve any type of security or investment but is most commonly associated with the purchase of shares of stock in a company. Value investment deals with purchasing securities that are reasonably priced given their underlying fundamentals, including growth prospects. Ideally, the shares in the company should be trading at a price that is less than the intrinsic value of the shares and hence be considered a value stock. Being a value investor is no different from seeking value in the purchase of any good or service. We generally prefer to buy things when they are selling at a discount and not when they are selling at a premium."
Intrinsic value versus market and book value
Price is what a security sells for in the stock market; it is also called "market value." Intrinsic value refers to the price we would be willing to buy at, given the state of a company's fundamental metrics and future prospects. Intrinsic value is independent of price, and it too is in the eye of the beholder.
Book value refers to the value of a company's assets, minus its liabilities. Traditionally, all values were shown at their original purchase prices, but newer accounting rules stipulate that assets must be related to current value.
Investing versus speculation
Equity investing is not the same as gambling -- they have different underlying economics. In Las Vegas casinos, for example, we cannot expect to come out ahead because the odds favor the house. Investing, on the other hand, can provide positive returns over time.
That return is a reward for deferred consumption and shouldering risk. The authors added that investing is a long-term proposition, while gambling or speculating is typically focused on the short term.
Efficient versus irrational markets
Many financial theories assume that markets are "efficient," which is to say that prices reflect all available information. As a corollary, it must be assumed that there are no mispricing opportunities because all players possess all available information.
Rebutting that idea, the authors argued that most market participants are individuals, whether retail investors or professional fund managers, and:
"Individuals do not always behave rationally, so information is not always reflected quickly and rationally into prices. Individuals exhibit biases, react to greed and fear, and get caught up in speculative manias such as those previously mentioned for tulip bulbs, Internet stocks, and real estate. Market efficiency requires rational economic behavior, which is something often lacking in market participants."
Value versus growth strategies
Value investors base their decisions on "some underlying fundamental factor such as earnings," while growth investors make decisions based on future expectations about a company's stock price.
The authors disagreed with the idea that value and growth are mutually exclusive; they called it an "arbitrary dichotomy." In reality, they said, value investors must consider a company's growth as part of their assessment of revenues, earnings and operating cash flow.
Contrarian versus momentum investing
By definition, a value investor must be a contrarian. The value investor disagrees with the market's current or future valuation of an asset such as a stock, and sees a gap between intrinsic value and market value.
Further, a value or contrarian investor never makes decisions based solely on price: The market price must be compared with an estimate of intrinsic value, and intrinsic value derives from fundamental data about a company, industry or national economy.
Momentum investing (which the authors asked the reader not to confuse with growth investing), is based on recent price increases and speculation (a guess) that the price will go higher yet. In other words, they are going with the flow on the assumption that the flow will continue.
Good companies versus good investments
A good company may not be a good investment. Why? Because a company may have done everything right and outperformed its peers, but it will not be a good investment unless the share price is attractive. Without an attractive price, a good company will not provide a satisfactory return to the investor.
In discussing stock market pessimism in 2008, Buffett said, "In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: 'I skate to where the puck is going to be, not to where it has been.'"
The history of value investing
The authors wrote that Benjamin Graham is called the "Father of Value Investing" and the "Dean of Wall Street" for good reasons. His two books, "Security Analysis" published in 1934 (with co-author David Dodd) and "The Intelligent Investor" in 1949, have become bibles for value investors.
Buffett offered a third book for the canon, "Common Stocks and Uncommon Profits" by Philip Fisher, and of course Buffett's own annual letters to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholders have become part of essential reading lists as well. What Graham, Buffett and other value investors have in common is that they are buying into real companies, not stocks, while profiting from divergences between market prices and intrinsic value.
And, the authors pointed to Seth Klarman (Trades, Portfolio) and his book, "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor." They referred to this book as an investing classic and observed that margin of safety has become a foundation of value investing.
Authors Horan, Johnson and Robinson told us that strategic value investing involved "being thoughtful about the characteristics of a particular security rather than blindly applying some sort of trading or classification rule." In the introduction, they laid out some of the "thoughtful" distinctions that set value investing apart from other investing strategies.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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