Book Review > Value. The Intelligent Investor’s Guide to Finding Hidden Gems on the Sharemarket

James Carlisle, editor of the Intelligent Investor investment newsletter, has written a compact and useful book on value investing for retail investors interested in investing in listed shares of individual Australian companies.

First, the author provides just enough of the theory of valuation(¹) to give the reader sufficient understanding to undertake the practicalities of value investing; and, second, the discussion of Australian companies makes the material in the book more relevant and accessible to the Australian reader. For novice investors interested in learning how to invest directly in shares, as apposed to indirect investment through managed funds, it can be a challenge to make sense of the avalanche of conflicting advice. There are many different possible paths for the investor to follow in allocating and managing investment capital for the best risk adjusted return for that particular investor.

Books such that this one offers to be your guide into the investment labyrinth – and the particular path offered by author, as the indicated by the book’s title, is the ‘value’ path. This path is one travelled by some of the world’s most successful investors, including the father of value investing, Ben Graham and his most famous protégé, the world’s greatest investor and richest man, Warren Buffet, both of whom are referred to in the book.

So what is value investing? The essential proposition of value investing is that the market does not always price the shares of companies correctly – sometimes paying too much and other times paying too little relative to the company’s ‘intrinsic value’ or what the company is really worth. If the market operated efficiently all the time then price and value would always be equal. Expressed another way:

P/V = 1

Where P= price/ share quoted in the market and V= the share’s intrinsic or true value per share.

If the proposition of value investing is true, then it is possible to identify shares of companies where:

P/V < 1

More importantly, value investing proponents suggest that at different times in the business/market cycle it is possible to find companies whose shares are priced by the market at a deep discount relative to their true value (most usually during bear markets when market sentiment is most pessimistic):

P/V << 1

The investment advantage to the value investor of finding companies with deeply discounted shares relative to value is that not only do such shares present an opportunity of picking up a bargain with a large future upside reward potential (and who does not like buying a bargain?), but such shares importantly provide a ‘margin of safety’ such that if your particular estimate of a company’s value is not right on the money, the price you pay for the shares is still likely to have a positive reward/risk ratio (Chapter 4, p49).

There are two ways the value investor can expect to be rewarded by investing in companies with deeply discounted shares: first, at some time in the future (hopefully not too far), the market will recognize the error it has made and realize the company is worth much more than suggested by the price that its shares have been trading, resulting in a ‘re-rating’ of the company’s shares (meaning the shares trade on a higher price/earnings ratio than before because the market has turned optimistic (sentiment now positive) on future earnings growth). This is really a value arbitrage play – buying underpriced shares in the expectation of being able to sell them at a higher full price at a future time.

Second, finance theory says that the price an investor should pay for a share is the value today of a stream of future income to the investor stretching into the far future (Discounted Cash Flow (DCF) valuation discussed in Chapters 4 & 6). Because that future income stream is uncertain (and the far future is highly uncertain), investors discount its value based on their judgment of its quality (in terms of steady growth) and risk (volatility) looking forward. If the market has mispriced a company’s share price because it has discounted the future income stream of company too heavily relative to the risk to that income stream, then a value investor can buy that income stream (usually defined by the expected stream of dividends (often fully franked) to be paid by the company) on a very favourable reward/risk basis.

The key to success with value investing then is the confidence the investor can have in the ‘V’ part of the P/V ratio. The author addresses the ‘value’ question in some detail in Chapters 5 to 8 of the book, including asset valuation and a basic examination of a company’s financial reports (Chapter 5). Importantly, the author counsels against over fixation on the accounting numbers (Chapter 6) and for the consideration of the less easily measured quality characteristics of a company’s business (Chapters 7 & 8) when looking at valuation.

Whatever investment path an investor chooses, including the ‘value path’, a key consideration of managing investment risk is diversification. The author addresses this subject in the final chapter of the book when discussing the ‘value portfolio’. This may be the most important chapter of the book, because all investment involves risk and as investors we must appropriately manage the risk/reward balance if we expect to survive and succeed as investors even if we develop confidence in our ability to identify good individual companies to invest in that are trading at a deep discount to their intrinsic value.

Peter Miller is a member of the AIA.