The word ‘value’ is now so overused that it has almost become an example of the worst kind of corporatese language, especially the phrase ‘adding value’. This is unfortunate because this word has a precise meaning in investing. It has a history, a method, well-defined goals and a tremendous track record.
People’s instincts about what makes a purchase worthwhile has some harmful side effects when applied to investing. However, overcoming these instincts can be very profitable, which is what ‘value investing’ is.
Two contradictory instincts define how people spend their money. One is to buy expensive things in order to signal their wealth and status, and the other is to get a good bargain. Ideally, one would want both to be present together in any proposition. We would like status symbol possessions that normally cost a lot, but we would want to get them at a good bargain just for us. That sounds like an impossibly good deal, but then, the fun of getting a deal is the maximum when it’s good.
It’s a natural technique to use the price of something to judge its intrinsic value. People express their wealth and their status in society by buying things that are more expensive. Whether it’s something trivial like a pair of socks, or some large expense like a car, or even a house, rich people spend more on the same kind of things. This behaviour is a part of human nature and really, there’s nothing fundamentally wrong with it. People acquire wealth to signal status and it brings them a feeling of fulfilment to be able to do so.
However, this belief that expensive things are better shapes human behaviour in some surprising ways. The strangest example that I have found is that in drug testing, patients have been observed to improve more if they are told that the medicine that they are being given is more expensive. It sounds unbelievable but the same medicine has a more beneficial effect on disease if the patient believes that it’s more expensive This means that although we tend to instinctively look for bargains, we don’t always make correct judgements about the value of things. Instead, we use price itself as an input to determine whether something is a good bargain. This sounds like circular logic, and it is.
So if this is an element of human nature, then what is its effect on investing? The more a stock rises, the more people believe, instinctively, that there must be something good about it. In a sense, the cause and effect is reversed. At its heart, value investing is the style of investing that does the opposite.
There are a variety of ways of defining value investing, but they all boil down to the fairly simple concept of buying quality stocks that are undervalued. It’s about buying cheap, and about being aware (and even suspicious!) of the idea that if something is expensive, then it must be good. Investing in a stock is an exercise in accepting uncertainty. You can analyse the likely future and hope that the company will do better and the stock will rise. When the stock rises you will be able to sell it at a higher price eventually. These future events are not dependent upon anything you can do. Anything could happen to the company, its market, its industry, the country’s economy and indeed the global economy that could derail your expectations.
All that is in the future and you have no control over it. The only thing you can control is the price at which you can buy the stock, or rather, whether you buy it at all at a given price. Everything that happens in the future is shaped by the price. Here’s the most important part of this concept: unless the price is defined, no investment can be said to be a good one. The exact same investment can be good or bad depending on what your price was. It is simply not possible to judge an investment without the context of its price, at least in the positive sense. In the negative sense, there are equity investments that are bad regardless of the price. However, there aren’t any investments that are good regardless of the price. Which is where the value of value investing comes from, and why it really does add value to your money.
(The author is the Founder and CEO of Value Research)