The term “value investing” is one of those words where the more you think about it the weirder it becomes. What is value after all? It seems anything can be value investing, because value is in the eye of the beholder.

Security Analysis author Benjamin Graham made the comment in his book Intelligent Investor that

“Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.”

Let’s take a step back for a few minutes. One of the most basic rules of business, if not THE most basic rule is you sell your products for more than it costs to create or obtain them. This is simple. If you are going to open an ice cream shop where your cone has $.25 worth of ingredients and $.50 worth of labor and rent in it you need to sell it for $.75 if you want to stay in business. This concept is so simple that even children understand it. Have a child purchase an item for a few dollars and then ask to buy it off of them for less than they paid, they’ll protest.  It simply makes sense.

Unfortunately, this business logic doesn’t extend to the stock market. Our fictitious ice cream shop selling cones for $1.00 that cost $.75 would trades for less than the trendy ice cream shop selling the same cones with the same cost structure for $.50.  Why is this?

In the stock market, there is a second dynamic at work, it’s investor psychology.  It isn’t just what the underlying business is doing, it’s what other investors are willing to pay.  In our example investors prize trendiness and losses over profits, and so they are willing to pay more for company B. Of course there will be stories explaining why B is better than A. The psychology is that investors feel that since they love company B that everyone loves company B and they will always be able to sell their shares for more than they paid.