Value Investing Explained

Today’s video will explain value investing… not just the basics of what it is, but also the different types of value investing and how they behave in different environments, how I’ve used it to consistently beat the market, and how Warren Buffett’s value approach was different than what the popular value ETFs and index funds are doing.

I’ll start with a quick anecdote. Value investing has always been somewhat of a funny concept to me. I mean, think about it… isn’t ALL investing value investing?

Who looks at a stock and says “are you out of your mind!? NO WAY this company is worth that much! … I’ll take 100 shares.”

No investors are buying things that they think are NOT a good value, so what distinguishes “value” investors from other kinds of investors, like growth investors?

The simplest way to understand this is by focusing on the three ways stocks can make you money.

I explained this in greater detail in my growth vs. value video, but the short version is that they can grow their earnings, their valuation can increase, or they can pay dividends.

Growth investors look for companies that will grow their earnings faster than most other companies, over time.

Value investors look for companies that they think are being mispriced by the market… they’re cheaper than they should be but they won’t stay that way forever, like they’re on sale.

The real fallacy of the whole growth and value dynamic is that in order to determine if you think a company is a good value, you have to calculate its intrinsic value… aka what you think it SHOULD be worth. To do that, you have to factor in its future growth potential. So… in reality, both earnings growth and valuation matter to all types of investors, but growth investors just focus on FASTER GROWING companies, and value investors focus on companies they think are cheap, and will go back up to their fair value.

Maybe the best way to bring this difference to life would be to look at two hypothetical stocks.

Let’s say one of them has a P/E… price to earnings ratio… of 100. That’s incredibly high.

And, let’s say they’re projected to grow their profits at 50% per year for the next 5 years… also very high.

No one would realistically expect them to keep a P/E ratio of 100 forever. The average for the stock market is usually in the 15-20 range. So, if they’re growing their earnings at 50% per year, but the price people are willing to pay for those earnings comes down, the stock price could still easily go up 20% per year. That would be the type of company a growth investor would want because of the fast earnings growth. A value investor probably wouldn’t be interested because the P/E ratio would be expected to go down, and they’re in the business of finding companies where the P/E ratio is expected to go UP.

Let’s think about another company… it’s an oil company and oil prices have come down a lot. We’re in a recession and everyone is super negative about the outlook for oil demand, so everyone sold out of the oil stocks. You find an oil stock that has a historical average P/E, of 12 but now it’s trading at a P/E of 8, a 33% discount.

You don’t expect much growth either, but it pays a nice dividend while you wait, and you’re pretty sure people won’t be down on oil stocks forever.

That company could also go up 20% per year as the valuation recovers back from 8 to 12, and a value investor would be all over an opportunity like that. A growth investor, not so much. There’s not enough earnings growth.

So while every stock investor is looking for stocks that will go up, growth and value investors just tend to go about it in different ways.

Now, even WITHIN value, there are a few different approaches.

Not all of these are official industry terms, but I’ll break them into 4 categories: regular value, deep value, dividend value, and intrinsic value.

“Regular value” is just my term for the most common, standard, value approach. This is what most indexes and index funds do.

It takes some valuation metric like P/E or P/B ratio and picks the stocks with the lowest ones. Simple as that.

Take the Russell 1000 Value for example. This is probably the most common value index, and it’s the basis for IWD, VONV, and VRVIX. It focuses on companies with LOW price to book ratios, low forecasted earnings growth, and low historical sales growth…. WHY you would want to target companies that are growing slowly, I don’t know, but over $70 billion dollars of people’s money is doing it. Insane.

S&P does it slightly differently when build their value index. They look at companies based on 3 different financial metrics, price to book ratio like Russell, but also price to earnings ratio and price to sales ratio.

What I’m calling regular value investors will all use something slightly different, but directionally the same. They focus on cheap stocks based on some arbitrary metric.

In my opinion, there are 2 major flaws with this approach.

First, these ratios are usually either looking backward or only 1 year forward. So, for example, price to earnings or P/E ratio usually compares the current price to either the last reported annual earnings or the estimated next reported annual earnings. But… companies are going to be around for a lot longer than 1 year, and MOST of the value often comes from growth and earnings that are more than 1 year away. So, you’re valuing companies based on a really incomplete picture. If two companies are projected to have the same earnings next year, but one is going to grow their earnings at 30% per year after that, and the other is only going to grow at 10% per year after that, which would you rather own? The one that’s going to grow faster, right? So it SHOULD cost more today because of its future earnings prospects, but those won’t be reflected in these basic financial ratios.

The second flaw is that those metrics aren’t useful for all types of companies. For example, when a company buys another company for more than the value of their assets, the difference in price goes on their balance sheet as “goodwill.” Goodwill is generally thought of as like… the value of their brands. It’s intangible, but it has value.

Well, let’s say a soda company buys out a chip company, a pretzel company, and a cracker company. They’ll have LOTS of goodwill bulking up their balance sheet.

But what if a different soda company starts their OWN chip company, pretzel company, and cracker company, which are equally as successful. That company will have a way lower book value than the first one, because they don’t have all that goodwill. Their brands might have the same amount of value, it just won’t be reflected on the balance sheet. So, because of the lower book value, if the companies trade at the same price per share, the price to book ratio will make the second company look WAY more expensive, although it’s really not.

The second category of value investing that I’ll cover is deep value. This one is my favorite because it’s the way I would describe my own investment style.

Deep value investors like me LOVE to find things that are beaten up, that everyone else hates. Someone once described me as the kind of investor that likes to run into burning buildings.

That’s not literal, of course, but it definitely makes a point. Deep value investors are not afraid to take some risk. Unlike the other types of value investing, this style is REALLY focused on upside potential.

Inherently, when something is down a lot, it’s down a lot for a reason. If you think that reason is stupid, you can buy at fire sale prices, and then reap the rewards when everyone else figures out what you already knew.

On the other hand, you can think that the reason is stupid but if you’re wrong, you can end up being the one that was proven to be stupid. Inevitably, if you do this enough times, you’ll have some of both.

Deep value investors look for opportunities where they have a DIFFERENTIATED view from the market. Usually, this is in something the market hates, or is really scared of. In MY experience, the best opportunities are ones where you are virtually certain it’ll go up in the long run, but it’s down a lot in the short-term because of a factor that you KNOW is temporary.

It’s risky to do this with individual stocks, because any company can go bankrupt, so I prefer to do it with index funds and ETFs. It’s much less likely that an entire country or industry will simply disappear.

For example, in 2020 the price of oil LITERALLY went negative. Oil companies had to PAY people to take their oil. Was that sustainable? Obviously not, so an energy stock ETF would have been an obvious deep value buy at the time.

I did a video where I laid out my investment process in great detail. It’s probably one of the most value investment videos I’ve ever done, and hardly anyone has watched it. Please go watch it! Here’s a little teaser:

             https://www.youtube.com/watch?v=0jLIDSVKeZ0

Clip: 00 – 017, end after “15 years”

Don’t worry, I’ll put a link up to that video at the end.

But for now, let’s move on to a type of value investing that’s TOTALLY different than that, dividend value investing.

Really, you could just call this dividend investing, but often a focus on companies that pay high dividends RESULTS IN a portfolio that leans toward the value “style” of companies.

I even did a video on an ETF recently that calls that out in its name, CGDV or Capital Group Dividend Value.

Not all “value” companies pay dividends, and not all dividend paying companies lean toward “value,” but there’s a lot of overlap. That’s because, in general, companies that have a lot of growth opportunities tend to invest most of their profits back into their business to grow. If they’re doing that, then they’re less likely to pay a dividend, and more likely to be growing their earnings faster – aka be a growth company. Companies with FEWER growth opportunities often have more cash left over to pay dividends, and they’re often cheaper because they’re not growing as fast – aka value companies.

Deep value companies tend to do well when there’s a major shift in the market. Whatever someone hated, now they don’t hate it anymore. That can be the overall market, or just a particular segment of it, like our energy example.

Dividend value, or just dividend paying companies, in general, tend to be much more stable, steady-eddy types of investments. They don’t offer as much upside potential as high-growth companies because they’re not growing as fast. They don’t offer as much upside potential as deep value companies because they’re outlook isn’t as likely to change drastically. They tend to hold up better than the stock market in downturns because investors hate uncertainty in downturns. If we go back to the 3 sources of return…. Earnings growth is definitely not certain in downturns, at least not for most companies. Valuations like the P/E and P/B will usually be falling since there’s a lot of selling pressure in the stock market. But dividends… well, that part of your return is usually pretty steady because companies HATE cutting their dividends. If they do, everyone will think they’re about to go bankrupt and sell out. Cutting the dividend is a sign that you don’t think you can afford it anymore. Growing dividends is a sign of confidence in the future of the company. Companies that consistently pay dividends, and ESPECIALLY companies that consistently grow their dividends, tend to hold up better than the market in most downturns.

You could also think about it this way. When the market is going up 20% in a year, your measly 3% dividend isn’t that exciting. But when the market might be flat or DOWN, that 3% dividend starts to look pretty good.

Our last type of value investing is intrinsic value investing. If you ask the market, this isn’t a type of value investing at all. Only cheap stocks based on arbitrary flawed metrics count. If you ask ME, I would say this is the only TRUE value investing. Intrinsic value is what you think a company SHOULD be worth, after analyzing it. It factors in every source of return, and projects it out into the future. This allows you to buy fast growing companies, slow growing companies, tech companies, oil companies, high dividend paying companies, and no dividend paying companies. It puts them all on a level playing field and lets investors REALLY focus on where they’re getting the best “value,” without having to box themselves in to any arbitrary metric.

You know who uses this method? Basically all of the most successful investors in the history of the world, but I’ll focus on the one you all know, Warren Buffett.

Warren Buffett is widely considered to be a value investor, but he didn’t just blindly buy the cheapest companies. In fact, he didn’t buy the cheapest companies at all. He said “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

And that brings me back to the point I made at the very beginning. Aren’t all investors “value” investors? Yes, in terms of intrinsic value, they are. Well, unless they invest in value index funds.

As investors, we can slice and dice things a million different ways to make ourselves sound smart, but you know what it really all comes down to? Finding companies that will go up. Quality growth, deep value, dividend value, high growth… they all have merits and none of them are universally right or wrong. But… since a TON of funds and ETFs are classified this way, I hope watching my value and growth series has helped make you smarter, so that you can make better investment decisions.