Introduction to Value Investing

Background

Value investing is an investment strategy whereby investors purchases stocks which are trading at a significant discount to their intrinsic value [1]. This is to say that, given a stock is trading at a certain price, a value investor would purchase this stock as they believe it is undervalued and that in the long term, the stock will significantly rise in price, reaping benefits in the form of the original investment rising in value. This method of investment, devised by Columbia University graduate and ‘father’ of value investing, Benjamin Graham has become very popular. In his early 20s, Graham secured a job on Wall Street and was earning over $500,000 annually from his investments [2]. However, the Great Crash of 1929 led to the loss of almost all of his endowment, which inspired him to write his famous book, (along with others), “Security Analysis”, which is where the fundamentals behind value investing began to take form. Graham’s fundamental idea was to analyse different factors such as assets_, (e.g. cash, inventory, buildings),_ earnings and dividend payouts as a method of finding the intrinsic value of a stock. Once the intrinsic value is found, providing it is more than the current market price of the stock, the investor should hold the stock, (maintain a long position), until the market price and the intrinsic price converge, so that the stock price reflects its true value – at which point the investor should sell. This is the idea of a mean reversion. Many people have seen the credibility of Graham’s idea of value investing, amongst his successors include businessman Warren Buffett who has a net worth of $87 billion [3].

How Can Stocks Become Undervalued?

There are a number of reasons why a stock can be undervalued, the most prominent being the herd mentality of investors. This idea maintains that investors are irrational as they invest psychologically rather than empirically, i.e. they act upon their feelings rather than the information in front of them. For example, an investor who is looking at the stock price of a company may find that if they had invested 10 weeks ago, they would have earned a 10% return on their investment, so they decide to invest now as they don’t want to miss out on future gains. This may seem a logical way to invest, as huge companies such as Amazon have consistently seen rising profits translating to rising share prices over a long period of time. However, although this has been the case for Amazon and certain other huge firms, Amazon’s joys do not reflect the majority of the market.

Furthermore, investors are also loss averse – meaning that the sadness that they get from a loss is greater than the happiness they gain of the same magnitude, (Prospect Theory – see graph). This means that when they see a stock price decreasing, they wish to minimise their losses by selling as soon as possible. This behaviour, when amplified across thousands of stocks, may cause disturbances in the market and lead to a stock becoming undervalued.

Another common reason why a stock may be undervalued is bad news – a negative press story can lead to investors selling that particular stock. On the other hand, just because a company has suffered one piece of bad news does not mean that this trend will continue in the long run. Take the example of Nike’s release of the Colin Kaepernick campaign: following the announcement of the advertisement, Nike’s share price dipped 3.2%, however by the next week shares rose to $82.24, which was higher than the pre-ad announcement closing level of $82.20 [4].

The third reason we’ll explore by which a stock may be undervalued is because it is unnoticed. Stocks that aren’t household names such as Apple, Facebook or Netflix may not receive attention from investors as they will most likely be small-cap, (low share value), foreign, or generally less well-known. One example of a small-cap stock that was worth investing in was, ‘Arrowhead Pharmaceuticals’. The medicine developer grew 354% over the past year, achieving a market capitalisation, (share price x share quantity), of $1.8 billion [5]. This was due to increasing attractiveness of its pipeline, (drugs that are being researched and tested with the aim of getting approval from regulators), which contains three liver treatments that are in Phase 1 of development, having passed the pre-clinical and pre-IND stages.

Case Study – Just Eat (JE)

After Uber’s announcement to potentially purchase UK-based takeaway food delivery rival Deliveroo, shares of competitor Just Eat plummeted 7%. This was likely as investors saw that two leaders in the takeaway industry joining together may lead a lessening of competition in the market, leading to Just Eat struggling to match the lower prices that the new firm would be able to set with their large market share and therefore potentially having to spend more on marketing costs, increasing its costs and cutting profit margins. Also, with Uber’s global infrastructure from its car-sharing business, it is clear that Uber has the technical knowledge on how to run a business effectively, posing as an even more significant threat to Just Eat and other rivals who may struggle to innovate or offer a broad range of high-street restaurants.

However, this may not necessarily be the case, as Just Eat already has one third market share in the UK, which means it has already established a relatively strong consumer base. Also, the strategy of Just Eat is different to that of Uber Eats and Deliveroo in the sense that Just Eat focuses on ‘second tier’ towns, (which covers two-thirds of the UK), locations where UberEats and Deliveroo are weaker [6]. Therefore, the fact that the market is already split into those with higher income and those with lower income suggests that there is ample room for all existing takeaway companies to thrive, hence why I believe Just Eat is an undervalued stock at its current price (607GBX) [7].