Value investing has become a diluted term. So, I’ll start with what it isn’t.
Value investing isn’t about buying cheap junk. It’s often painted that way these days, and in studies or comparisons, it’s constantly defined by a low price-to-book ratio or low price-to-earnings ratios, even though those metrics alone say absolutely nothing about the actual value.
Value investing also isn’t one narrowly defined style. It’s simply about buying something for less than it’s worth, with a healthy margin of safety.
I’ll borrow a term here from Michael van Biema, a professor who taught investing at Columbia Business School for years. He called value investing a spectrum. On that spectrum, you could say that Deep Value investors (which some confuse with buying junk) and Quality/Growth value investors are the two extremes. At least, if you approach quality investing like Buffett, and not like what I see constantly today, which is more like momentum/growth with a quality aspect, rather than true value investing.
The Four Value Investing Styles
Let’s quickly run through four styles of value investing that Michael van Biema defined.
First, you have the classic value investors, the Benjamin Graham acolytes who search for hidden value on balance sheets and what he called “wounded ducks.” The latter are companies facing a temporary setback, making them so cheap you simply can’t ignore them.
This type of value investing focuses on the companies’ balance sheets, looking for big discrepancies between the price being paid and the accounting value. Naturally, other aspects count too; you always want at least a minimal level of quality. Crucially, you want to be sure they don’t have too much debt.
The thing is, you can find well-managed, profitable companies whose prices are driven down very low by market conditions, turning them into opportunities.
This is Deep Value investing: buying a dollar for fifty cents because you have the insight that tough times pass, and on top of that, you have the patience to wait for it. You’ll know which companies in our portfolio fall into this category.
The Other End of the Spectrum
All the way at the other end sit the Quality/Growth value investors. There isn’t an investor alive who doesn’t like quality and growth in the companies they hold. The key difference that sets the value investor apart is that they don’t pay for speculative growth, or even for any growth at all. A value investor realizes the future is uncertain. Not paying for that growth is their margin of safety.
Warren Buffett is often called a quality investor nowadays, but make no mistake: he has always remained a value investor. He has certainly shifted from the deep value side to the quality side of the spectrum. However, he never became a growth investor or a quality investor as we know them today. His “wonderful business at a fair price” quote is used very often, but that “fair price” is often misinterpreted. Buffett didn’t pay for the growth of those companies. So, his fair price is calculated without growth, or only including 100% certain growth.
So, yes, Buffett is a growth/quality investor too, but he remains a value investor by not paying for that future growth.
When I read today that investors classify 15-25 times the price-to-earnings ratio as a “fair” price, I know they are paying for that growth—and at 25, they’re paying pretty steeply.
The most important trait for this type of investor isn’t their math or Excel skills, but the discipline to stick to their principles and not chase prices when buying.
Selling is also trickier here: where a deep value investor will sell when the price approaches fair value, a quality/growth value investor shouldn’t sell too quickly. In my opinion, selling is the hardest part with these types of stocks. You’ll find some of these in our selection too.
Special Situations and Activists
Two other styles are investors in so-called special situations and activists.
Special situation investors hunt in the realm of spinoffs, mergers, turnarounds, and so on. This is a very profitable way to invest—just look at Joël Greenblatt, whose fund, Gotham Capital, achieved over 40% CAGR for more than a decade using this approach. However, it’s also the most difficult.
As an investor, you have to be able to see through the situations to understand why the profits aren’t normal, and determine what the normal profits will be in the future. You base your valuation on these normalized earnings. You then need to be relatively sure they’ll materialize, and naturally, build in enough margin of safety in case things don’t go exactly as expected.
Finally, the activists are closely related. Here, there are no special situations, but the activist sees that the company isn’t generating the profits or cash flow it could be. They step in to throw their weight around, influencing decision-making and management until things improve as they see fit. This might involve divesting divisions or investing extra in others. Special situations often emerge from this process.
To be an activist, you often need quite a bit of capital; the other three are perfect styles for all portfolios. It is important, though, to know which style suits you best and where you can stick most reliably to the principles.