The basic principles behind the style of investing known as value investing are simple. Benjamin Graham is widely regarded as being the man who laid out the basic principles behind the strategy in the first half of the 1900s. Graham believed that what investors needed to do to earn positive returns was to buy stocks when trading at a deep discount to intrinsic value.
In Graham's time, the intrinsic value could be anything from the book value to the tangible net net asset value of the stock. This is a simplified version of the strategy, but the basic principle is there.
The one drawback of this strategy is that it depends on other market participants noticing the gap between intrinsic value and the stock market quote, and noticing it later than the investor. This occurrance has become far less common as information about the stock market has become more widely available.
The price of a stock is determined by supply and demand. If there are more buyers than sellers, the value of the equity will increase. This means that for an undervalued equity to reach its intrinsic value, the number of buyers will have to exceed the number of sellers.
This throws up another problem. There will never be one set intrinsic value of a business. Every investor and analyst will have their own method for calculating value, and every investor and analyst may reach a different conclusion based on their levels of experience and techniques used. These challenges mean there is never any guarantee that a cheap-looking stock will ever become fully valued.
Creating value
Graham and his student, Warren Buffett (Trades, Portfolio) found a way around this problem. If they couldn't trust the market to place the proper value on an equity, then they would have to do it themselves.
Graham and Buffett took part in several activist situations, which allowed them to realize substantial returns on their investments in cheap-looking stocks without relying on the market.
Seth Klarman (Trades, Portfolio) is also an advocate of a similar approach, although he rarely takes an activist stance. Instead, the hedge fund manager has said investors should seek out situations where there is a catalyst for value creation on the horizon. In his book, "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor," Klarman explained:
"Catalysts for partial value realization serve two important purposes.
First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback.
Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future.
Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs."
The author also explained that without a catalyst, "underlying value could erode," and the gap "between price and value could widen with the vagaries of the market."
This is something investors should consider before taking a position in what looks to be a deeply undervalued security. If no event on the horizon could cause the gap between value and price to narrow, the discount may last indefinitely. In the meantime, there's no telling how the business's fundamentals may perform. I have seen countless situations where a cheap stock has remained cheap for years because the market has continued to overlook the opportunity.
Investors just don't want to be stuck in an equity for years with no returns - that's easy enough to understand. This then becomes a self-fulfilling cycle. Investors avoid the company, which means that stock underperforms, which drives more investors away, and so on.
Graham, Buffett and Klarman all realized that one does not beat the market by sitting and watching one's money languish for years.
