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The search for true value

April 16, 2020

reading time: 5 minutes

by Sidi Staub

True value

Value-oriented investors try to identify undervalued stocks and invest in these profitably.

Every investor knows that share prices fluctuate considerably over time. Investing successfully in stocks would therefore seem like quite a simple matter: you buy when a stock is cheap and sell when the price has risen. The problem is: when exactly is a stock cheap – and when is it expensive? Is it even possible to find that out? These questions are key for every investor – and not only when share price volatility is high.

Proponents of modern portfolio theory are of the opinion that this is not possible. In their view, there is no such thing as cheap or expensive. They believe that stock markets are absolutely efficient, and that each stock is therefore correctly valued at all times. Consequently, future price movements cannot be predicted. Proponents of value investing have quite a different view. They reject the hypothesis that markets are efficient and are convinced that each stock has a correct, so-called intrinsic or fair value. But because markets are inefficient and driven by emotions, the stock price can temporarily deviate from this value.

Based on fundamental analysis

Investor legend Warren Buffett
Warren Buffett

If the current stock price is substantially below fair value, then it makes sense to buy the undervalued stock and wait until, sooner or later, the price rises to the correct value. Conversely, one should part with a stock if the current market price is above fair value. Value investors use fundamental analysis to calculate this and look at key figures such as the price-earnings ratio, dividend yield and profit growth of a company, but also at qualitative factors such as the quality of management.

 

The legendary Warren Buffet, whose many successful investments would seem to disprove the efficiency hypothesis, is a paragon of value investing for many investors who pursue this approach. His investment strategy is based on targeted investments in undervalued equities. Berkshire Hathaway, his investment company, regularly achieves above-average returns for shareholders – and has done so for over 50 years!

But value investing has been around for much longer than that. Benjamin Graham, an American economist and investor, is considered by many to be the father of value investing, and Warren Buffet was among those who attended his lectures. In 1934, Graham and his colleague David Dodd published the book Security Analysis, still the bible of value-oriented investors today, and in 1949 the bestseller The Intelligent Investor, a somewhat simplified version, which was reprinted several times, most recently in 2003.

Conclusion

Those who believe in efficient markets tend to invest in low-cost index funds, which at best, however, achieve returns in line with the market average. On the other hand, those who are convinced that temporary mispricings exist on the stock market should look for the best investment managers for their assets who can identify such mispricings and profit from them.

Photos: KEYSTONE-SDA / DPA / Christian Sommer.

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