Value investing can trace its roots back to Black Thursday, the infamous Wall Street crash of 1929. As this event unfolded, it nearly wiped out a then 35-year old Benjamin Graham and the investment firm he worked for. The crash inspired Graham, a professor at Columbia University, to search for a more disciplined and safer way to invest for the long term.

In the years to follow he authored the legendary book, ?Security Analysis?, alongside David Dodd, his protege at the time. The duo set out to define value oriented investing and the use of fundamentals to guide the valuation of securities. This concept was developed and taken to new heights by renowned investor Warren Buffett, who studied under Graham at Columbia and was his only pupil to receive an A+.

The heart of value investing

The heart of value investing lies in the calculation and subsequent comparison of two figures, the current market value of a security versus its intrinsic value. Calculating the intrinsic value is where the true worth and difficulty lies. This is because there are a number of ways to value a company based on asset values, various price multiples using earnings, sales, book value, cash flows and dividends, among other financial statistics.

Graham?s perspective of value investing took the view of analysing the relationship between a company?s net current asset value and its stock price. The process follows two key events: making a decision to purchase and making a decision to sell. Graham was famously quoted as stating that shares should be bought at no more than two-thirds of the net current assets of the company, after deducting all prior charges and attributing no value to its fixed assets. In effect, you are obtaining the assets that have a realisable cash value at a discount and picking up the rest of the company for next to nothing. The decision to sell was considered far easier. The investor would determine when the share price had advanced to a value equal to the value of the net current assets ? a value that had already been established.

When the method worked, the result would be at least 50 percent appreciation. Graham and Dodd tested this method between 1946 and 1976 and they were able to generate annual compound returns in excess of 19 percent.

Markets have developed much further than in the days of Graham and Dodd and with widely available information on companies, it makes it harder to identify shares that meet this criteria. In the years that followed, Warren Buffett developed this system along with theories taken from Philip Arthur Fisher, a pioneer in the art of growth investing.

Both value and growth methods are considered long term and disciplined processes of investing. In a letter to shareholders in 1996, Warren Buffett stated, ?You must resist the temptation to stray from your guidelines. If you aren?t willing to own a stock for 10 years, don?t even think about owning it for 10 minutes.?

?Growth and value investing are joined at the hip? ? Warren Buffett

There is a fundamental commonality between the two methods and it lies with the view on earnings. Value investors look for companies that are cheap relative to its intrinsic value, but show interest in earnings growth so long as it can be acquired cheaply or at good value. Growth investors are concerned only with earnings growth and are willing to pay for it. The theory around growth investing focuses on above average earnings growth relative to the industry or market peers. It ignores typical valuation metrics such as price multiples.

However, if value investing focuses on low priced stocks relative to earnings, growth investing can be taken as searching for high priced stocks. The Dividend Discount Model shows that a high priced stock can be justified with a high growth in earnings.

Another stark contrast between the two methods occurs when considering the process of valuing a company. Value investors consider quantitative criteria of asset values, price multiples and discounted cash flows and earnings. Growth investors look more to qualitative factors on judgements about the business, its industry, the management and its ability to extract future earnings growth. In this respect, a growth investor is considered less prudent and more open to risk than a value investor.

Swings and cycles of value investing

Value investing has managed to stand the test of time. However, it has not always been the mainstay of investment principles that Graham and Dodd once thought it would be. During the 20 years prior to the late 1990s what can be considered value stocks outperformed those considered to be growth stocks. When the dotcom boom was pushing the markets to new highs during the late 1990s, value stocks took a pummelling and value investors were a scarce group. To begin with, finding value companies was extremely difficult in a market where the majority of stocks looked overvalued on traditional valuations criteria. It seemed as though any dotcom stock could be bought for any valuation and you could double your money in a short space of time.

As the stock market went into decline, it seemed as though the key to smart investing lay with finding companies whose share prices were good value relative to earnings and dividends, and where there were assets to support debt. Hence the revival of value investing during the early 2000s. This swing and cycle of value and growth investing is a common feature and the difficulty lies in when to make the call on the market and choosing which approach to undertake.

Value investors can at times be non-believers of the efficient market hypothesis, but they have conviction that the market will eventually see quality in the stocks that were once undervalued. While there are pitfalls associated with value investing it has evolved, not only as a result of the natural dynamism of stock markets over the decades, but as a result of better investment management processes. This expansion of the original theory has served to eliminate the pure quantitative focus in value investing and limit the risk of finding value traps.

What remains though is the focus on long term investing through all market cycles. Research has shown that value investing does work, as does the growth model. However, it was noted that over the long term and through all types of business cycles, especially in market downturns, the value method has worked remarkably better.

There are natural swings and cycles in long term investing but the focus to identify excellent businesses, purchase them at fair prices and maintain the discipline to wait for the market to revalue at attractive prices, will help the investor prosper through most, if not, all business cycles.