Style, the theme of today’s post, is something I promise I will only give you tips on when it comes to investments. My former students will attest that clothing style is far from my realm of expertise, to put it mildly, and my current hair style in the Covid-isolation-social distancing world has turned into something between “Cro-Magnon”, and “1970s Game Show Host”. That’s ok, because unlike fashion style I am qualified to tell you about investment style, and it’s a very good thing to know about even though it won’t get you any more “likes” on your latest Instagram post.
When it comes to stocks, the two main schools of thought regarding investment styles are called “Value” and “Growth”. Both are attractive sounding words; can’t I have both when I buy a stock? Hopefully, but when it comes to picking stocks, these words describe two very distinct styles or philosophies.
First, the “Value” style of stock investing, and tomorrow I will post an explanation about the Growth style. Value investors are looking for, you may have guessed it, stock whose current price represents a good value. OK, but what is the value of a stock? I always say in my classes that the value of any asset is what someone else is currently willing and able to pay you for it. When I say this to my classes, what I’m really talking about is “market value”, which is very easy to find for stocks listed on an exchange. Like many terms in finance, “value” can mean different things, so when we’re talking about stocks, we need to look at a different element or dimension of value.
For Value investors, the “value” they try to determine is really “intrinsic value”, which means the value something has in and of itself. Let’s look at it a different way: let’s look at a collectable gold coin. It may have a value of $2000, which means someone else will actually give you $2000 for it (it might be the price a similar coin sold for on eBay, for example). That $2000 price might have a few different elements that went into it. One of these elements we can call intrinsic value, and that is the value of the gold itself. Let’s say this coin contains 1 ounce of gold, and gold is currently selling for $1600 per ounce on the market. The intrinsic value of the coin is therefore $1600 (the value of its gold content); the other $400 might be what an collector is willing to pay for other features of the coin: it’s age, mintage, condition, design, etc..
It’s largely the same with stocks, but here is the bad news: there is no way to determine with 100% certainty what the intrinsic value of a stock is. This definitely falls into the realm of the “art” rather than “science” part of investing.
This does not mean that there is no value to value investing (ok, we got the obligatory pun out of the way!). In fact, I consider myself a value investor, and that was my philosophy when I was a stock analyst. Here’s basically how value investing works: stock analysts pour through every aspect of a firm’s financial statements, looking at the company’s assets and trying to assess what their actual value is (essentially using my definition above in most cases). This, in conjunction with what the company owes to others (its liabilities), and using formulas that differ very widely from investor to investor, as well as investment company to investment company, attempts to arrive at what the company is really worth on a per share basis. This is the stock’s intrinsic value.
So, if each investor and each investment company has a different way of assessing and determining intrinsic value, isn’t is possible each will have their own different intrinsic value figure? Yes! This is just one of the many things that separates the good analysts and good investment managers from the not-as-good ones. But most value investors use a similar strategy once they arrive at their estimate (and yes, it is very much an estimate) of a stock’s intrinsic value: they look for stocks whose current market price is below its intrinsic value (i.e. selling for less than it is really worth).
To illustrate, I will give you an example from one of the best mutual fund managers in the business. A few years ago I had the opportunity to spend an hour will Bill Nygren of Harris Associates, the outstanding manager of several Oakmark mutual funds. He is a top notch value manager, and described his process like this: when they find a stock with strong financials (i.e. in good financial condition) whose stock is selling for 60% of its intrinsic value, they consider buying it. When stocks in the portfolio reach their intrinsic value, they consider selling it. Notice I used the word “consider”, as there are a few other factors involved that I’ll get into in a future post, but for now, this is essentially how “value” investing works.
The point of value investing is to find stocks that are mispriced on the market, in other words, that investors have underestimated the true value of, and thus are willing to pay less for than they are really worth. Eventually, the theory goes, the market will see the true value of the stock, its price will rise accordingly, and the investor will make a nice return.
Tomorrow I’ll explain the “growth” style philosophy, and tell you why the distinction should be important to you.
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