I’m sure anybody who has found their way to this website already has an idea of what value investing is. Nonetheless, it is still valuable to lay out the value investing framework and discuss the core ideas that helped many investment greats achieve astronomical long-term returns.
Value investing is a half art, half science method of investing that involves the analysis of both quantitative and qualitative factors. It is the method that created the fortunes of renowned investors such as Benjamin Graham, Warren Buffett, Phil Fisher and Charlie Munger to name a few. The concepts of value investing were laid out in the early 1900s by Benjamin Graham and Phil Fisher. These ideas were then adopted by disciples such as Warren Buffett, who then added to and explained his ideas over the years in his annual letters and annual meetings with shareholders.
According to Charlie Munger, Vice Chairman of Berkshire Hathaway and a legendary value investor:
This one quote encapsulates what it means to be a value investor. It simply means to assess the underlying worth of an asset and buy it when it is offering an attractive return on your investment. It rejects purchasing assets based on speculation or guesses on where the price will move next. Rather, value investors act as though the market will close for the next 5 years. To practice value investing, an analyst needs to firstly understand the three main lessons taught by Ben Graham, in what Buffett calls “by far the best investing book ever written”, The Intelligent Investor. These are:
- Stocks are not just electronic symbols that constantly gyrate in price, but rather, they are pieces of businesses.
- The stock market is like a manic depressive business partner who is there to serve you not to instruct you.
- Always make an investment with a margin of safety to allow for any mistakes or natural vicissitudes of life.
Stocks as pieces of businesses
Considering a stock as part ownership of a business automatically alters your mindset. It shifts from worrying about the stock’s current price and earnings estimates for the upcoming quarter to thinking about factors that will impact the success of the business long-term. Seth Klarman, another value investing legend, once said:
So when we think about a stock, we must recognise that what will truly impact our investment success is the prospects of the business over the next 10+ years, not 10+ months. This leads to another incredibly important concept, which is to make an investment, one has to understand the business. This involves understanding its long-term drivers of growth, the business’ competitive position in its industry and how it generates its income. Having this orientation will remove our sensitivity to the daily prices and short-term events. Instead, it allows us to put our time toward searching for wonderful businesses that can be bought at attractive prices.
Mr Market is our servant, not our instructor
To explain the second point outlined above, Ben Graham created Mr Market, an allegory to describe his beliefs about the irrational stock market. In Warren Buffett’s 1987 letter to shareholders, he explained this concept to the world:
This concept is extremely powerful. Stepping away from the market and treating it as a crazy environment full of emotions gives value investors an edge. The auction-driven, irrational stock market allows value investors to independently assess the value of businesses, and then either accept or reject the prices offered for this business by Mr Market. This trait is common amongst all successful investors, for they believe the stock market is an arena to be taken advantage of, and for the rest of the time, to be ignored.
Investing with a margin of safety
The final concept is one that is logical and common practice in most other fields of life. If an engineer was tasked with the responsibility to design a bridge that can hold 40,000kg of mass, would they design it to capacity? Or would they instead ensure the bridge can handle 70,000kg, knowing that no matter what, the bridge will remain upright? This idea is directly applicable to investing. No matter how thorough our analysis is, there is always a possibility that things go pear-shaped. In these scenarios, value investors don’t suffer as badly as you may think, as they demand a margin of safety prior to entering the investment. The idea is to buy a business in the stock market when it is trading at a huge discount to its intrinsic value. This means that even if the assessment turns out wrong, the outcome will not lead to a huge loss of capital.
For example, using a 10% discount rate and a 5% growth rate to value a business might give a value of $100 per share. If bought at $50 per share, even if the business fails in execution and doesn’t grow at all, the return will still be okay. Paying the full $100 means a 10% return will be achieved if the business meets the 5% growth assumption. But what if it doesn’t? Paying $50 on the other hand means a 10% return will be achieved even if the business doesn’t grow at all, and if it meets the assumed 5% growth rate, the investment return will be outstanding
Harnessing the power of these three cornerstones sets value investors apart from the rest of the market. Most market participants check prices frequently and use the movements in price as indicators to make investment choices. Value investors ultimately take advantage of the swings in the market. They buy when others are selling and sell when others are buying. The key is not an incredible level of intelligence, but rather the emotional stability and control to recognise when certain businesses are too hard to analyse and to calmly purchase the wonderful ones even when the rest of the market is selling them off. To quote Warren Buffett: