Who is a Value Investor?

Morningstar is a widely used source of mutual fund information, and it categorized 38 percent of mutual funds as value funds in 2001. But how did it make this categorization? While it did look at the way these funds described themselves in their prospectus, the ultimate categorization was based on a far simpler measure. Any fund that invested in stocks with low price-to-book value ratios or low price earnings ratios, relative to the market, was categorized as a value fund. This categorization is fairly conventional, but we believe that it is too narrow a definition and misses the essence of value investing.

Another widely used definition of value investors suggests that they are investors interested in buying stocks for less than what they are worth. But that is too broad a definition, because you could potentially categorize most active investors as value investors on this basis. After all, growth investors (who are often viewed as competing with value investors) also want to buy stocks for less than what they are worth.

So, what is the essence of value investing? To understand value investing, we have to begin with the proposition that the value of a firm is derived from two sources—

1. investments that the firm has already made (assets in place) and 
2. expected future investments (growth opportunities). 

What sets value investors apart is their desire to buy firms for less than what their assets-in-place are worth. Consequently, value investors tend to be leery of large premiums paid by markets for growth opportunities and try to find their best bargains in more mature companies that are out of favor. 

Even with this definition of value investing, there are three distinct strands that we see in value investing. 

1. The first and perhaps simplest form of value investing is passive screening, where companies are put through a number of investment screens—for example, low PE ratios, marketability, and low risk—and those that pass the screens are categorized as good investments. 
2. In its second form, you have contrarian value investing, where you buy assets that are viewed as untouchable by other investors because of poor past performance or bad news about them. 
3. In its third form, you become an activist value investor who buys equity in undervalued or poorly managed companies but then uses the power of your position (which has to be a significant one) to push for change that will unlock this value.

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