Value investing is a style of investing that was popularized by Benjamin Graham and David Dodd at the Columbia Graduate School during the 1920s. The concept of value stocks wasn’t so well laid out then, and stock exchange investing was driven mainly by speculation and information. Graham began teaching his value investing approach at Columbia Business School in 1928. Two decades later, legendary investor Warren Buffett enrolled for the course. He mastered the worth investing approach and went on to become the richest investor ever. Here’s what he says about value investing:
“The basic ideas of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”
Value Investing is what kickstarted Warren Buffet’s now-legendary journey as an investor. In this post, you will also be able to learn the basics of value investing.
Basics of Value Investing
What is value investing?
Value investing is an investment approach that seeks to profit from identifying undervalued stocks. It is supported by the thought that every stock has an intrinsic value, i.e. what it is truly worth.
Through the fundamental analysis of a corporation, we can figure out its intrinsic value. The idea is to buy stocks that trade at a significant discount on their intrinsic values (i.e. they are cheaper than their true value). Once we buy an undervalued stock, the stock price eventually rises towards its intrinsic value, and makes a profit for us within the process.
Value investing is conceptually simple, though it does require effort to implement.
Here are the philosophies of value investing:
Component #1: Mr. Market
Imagine you are in a partnership with Mr. Market, where you can buy or sell shares. Each day, Mr. Market offers you prices for shares counting on his mood. If Mr. Market is feeling very optimistic, he will offer very high prices. In this case, an investor should sell the shares. If Mr. Market is during a very pessimistic mood, he will offer low prices, and this is often the time to shop for new shares.
Component #2: Intrinsic Value
Intrinsic value represents the true value of the company based on fundamentals. In the short term, market prices deviate from their intrinsic values thanks to changing market sentiments. In the future, market prices return to intrinsic values. This process allows us to make profits, because we can buy stocks when they fall below their intrinsic values. We then hold them until they return to their intrinsic values in the long term.
Component #3: Margin of Safety
The margin of safety is the essence of valuation. Since the estimates of intrinsic value involve subjective assessments, there is a possibility of being overly optimistic. By adjusting the optimism, the margin of safety can provide a decent cushion.
Component #4: Investment Horizon
Value investing works with an eye on the future, because that’s when prices return to their intrinsic value. Value investing doesn’t aim to predict what stock prices will do 2 days or 2 months from now. Instead, it aims to pick undervalued businesses that will outperform in the long term. This will eventually reflect in the stock price.
Warren Buffet’s Four Filter Approach to Value Investing
Warren Buffet’s four filter approach is a process by which one can reach an investment decision while keeping the qualitative also as quantitative factors useful investing. Here are the steps:
1: Identifying Circle of Competence
This comprises all the businesses that you are familiar with and thoroughly understand. For value investors, it’s important to take a position only in businesses that they understand. Value investors must focus solely on areas of business where they believe they need a foothold over the typical investor.
Likewise, staying away from what you don’t understand is equally important.
2: A Moat to Protect Your Castle
If we look at the castles, there is a deep moat all around. This moat was typically filled with water and crocodiles or other predatory reptiles to keep the attackers/enemies away. In value investing too, you ought to look to guard your castle.
In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage, wider is the moat. This moat would protect the business from competition. And if the firm is in a position to use its competitive advantage to widen the moat over time, then it’s the right business to be in.
Companies that have a good moat are ready to earn higher returns for its shareholders. And it is able to do so consistently year after year, every year. This in turn propels its projected stock value.
3. Able and Trustworthy Management
There are three main factors in assessing management:
- The results of the company
- The treatment of the company’s shareholders
- How well it allocates capital
4. A Sensible Price Tag
A sensible price tag for stock selection helps you build a margin for safety that we discussed earlier. It consists of valuing the company’s true market value per share by various valuation methods.