I figured I should post an article focused on what the entire site is about, value investing.
What is it? What does it mean? How do you use it as a strategy? And most importantly, does it work? These are the questions we will tackle in this article.
- Value investing is a time-proven strategy that focuses on investing in companies with an intrinsic value greater than the market price.
- The 5 pillars of value investing are invest in the business, understand Mr. Market, determine an intrinsic value, always have a margin of safety, and invest for the long-term.
- Several investors, including Benjamin Graham, Warren Buffett, Charlie Munger, Seth Klarman, Peter Lynch, and Mohnish Pabrai have had very successful careers using value investing principles.
What is Value Investing?
Value investing is essentially a strategy set forth by Benjamin Graham, often called the Father of Value Investing, in his seminal books The Intelligent Investor and Security Analysis. In these must-read books, Graham laid out his school of thought in great detail, explaining companies have an underlying "intrinsic value", and their stock prices often deviate significantly, for better or worse, from that value. With this theory, he simply believed investing in solid businesses at a discount to their intrinsic value would produce greater results with less risk. And as we'll see later, this worked out quite well.
Sounds so simple right? Well, at the time (early 20th century) it was actually a radically different strategy than the highly speculative mentality that was pervasive throughout Wall Street. He ended up teaching his philosophy to the great Warren Buffett -- seemed to work out well for him too -- and many others who have continued his legacy and have earned exceptional returns.
“Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process.”
— Seth Klarman
But if it's so simple and easy, then why doesn't everyone do it? For numerous reasons that I'll have to detail in a later blog post, private investors, fund managers, and professional analysts are consistently unable to best the market. This can be due to psychology, nature of the business (fund managers), or impatience. But most of them do not actually practice value investing, even if they say they do. That's because it takes time, patience, and determination to be a value investor. But it is by far the most time-proven, back-tested strategy, and below I outline the foundation of my value investing philosophy.
The 5 Pillars of Value Investing
Unlike some investing strategies, value investing is really quite simple. If you have common sense, elementary math skills, time, and the willingness to save money and invest, then you can successfully practice the art of value investing as well. Below I have summed up what I call the 5 pillars of value investing. If you follow these simple fundamental concepts then you will be well on your way to becoming a more successful, and happier, investor.
- Invest in the business
- Approach investing in stocks as if you were a business owner. That is, when you purchase stock, you're not just buying sheets of paper that can go up or down, you're buying a slice of the business. That means respect your values, seek well-managed companies, and never invest in something you wouldn't want to own. Do you believe in the company? Is it going in the right direction? Do you trust management? These are all questions you need to ask yourself before you invest in any business.
- Understand Mr. Market
- Many investors subscribe to the Efficient Market Theory (EMT), which basically states due to technology and the rapid transit of information, stocks are always valued correctly. Value investors believe that the market undervalues, or overvalues, stocks all the time. This can happen due to slumping economies, panicked sellers, or bubbles (think of the dot-com bubble). And history has proven them right so far. If you really want to see the EMT get taken to task, read the Warren Buffett article, The Superinvestors of Graham-and-Doddsville here. It's absolutely marvelous and proves that stock prices quite often do not resemble the underlying value.
- So... who is Mr. Market, you ask. Mr. Market was a fictional character described by Ben Graham in his book, The Intelligent Investor. The excellent metaphor will drastically change the way you view the stock market. Graham explained how everyday Mr. Market will offer you stocks for certain prices. Whether you decide to buy, sell, or do nothing does not matter to him as he will undoubtedly return and offer you brand new quotes the next day. The catch being Mr. Market is actually a highly manic-depressive fellow. When he's in a good mood, he's greedy and offers outlandishly high prices. When he's depressed, he's fearful and offers you the same stocks for profoundly low prices. This is Graham's way of saying the share's price quotes day-in and day-out say relatively little about the underlying value of the business. This is an extremely important point and, along with Margin of Safety, forms the two most crucial tenets of value investing.
- Determine an intrinsic value
- The next important concept is intrinsic value. Every business has an underlying worth, or value. To determine if we want to invest in said business, we need to know what it's worth, or at least have an idea. Which is why value investing is an art. It's impossible to put an exact number on any business valuation, but we can have an idea and even form a range where we would be comfortable buying shares. I'll discuss later a few ways to do this, but for now understand the concept.
“Price is what you pay, value is what you get.”
— Benjamin Graham
- If you're a savvy shopper, you already understand this. Just because that brand new, 4k TV went on sale does not mean it's turned to crap. It just presents you with a better opportunity to buy something you have researched and know its value. Stocks are the same way, except the sales can be for numerous reasons.
- Always have a margin of safety
- Now we have reached, in my opinion, the most important concept in investing history. Once you realize you're owning a slice of the company, understand Mr. Market, and have determined an intrinsic value range, you can decide if you want to buy, sell, or pass. And the principle margin of safety (MOS), will dramatically increase your odd of being successful. It means buying stocks at discounted prices relative to their fundamental value. This gives you a better chance of producing exceptional returns and offers you less downside, or risk, if the stock underperforms your expectations. For instance, if I buy a stock worth $100, for $50 a share, all I have to do is wait for that stock price to rise to its true worth. Personally, I look for a 25-33% MOS.
“All intelligent investing is value investing — acquiring more than you are paying for. You must value the business in order to value the stock.”
— Charlie Munger
- Invest for the long-term
- The last pillar is the easiest to explain, yet the hardest for most people to follow. Value investing takes determination, diligence, and, most importantly, time. Sometimes it can takes months, even years, for an investment to payoff. You simply cannot expect to purchase a stock on Tuesday and sell it for double the price on Friday over and over again. You also cannot expect to plug and play any stock into a certain screener and come out a winner consistently. Value investing takes due diligence and patience. But it's worth it. It allows you to invest in a time-proven strategy that decreases risk and increases returns. Just remember, there is no instant gratification. Only invest money you don't need for at least 3 years.
A Brief History of Value Investors
There have been several highly successful value investors throughout history, These include Warren Buffett, Benjamin Graham, Charlie Munger, Seth Klarman, Mohnish Pabrai, Walter Schloss, Irving Kahn, John Templeton, Bruce Greenwald, Joel Greenblatt, and Peter Lynch, just to name a few.
Peter Lynch, my personal favorite investor of all time, used a mixture of value and growth strategies while managing the Fidelity Magellan Fund from 1977-1990 where he produced an incredible average annual return of 29%. Warren Buffett's Berkshire Hathaway would've turned a $10,000 investment in 1965 into $85 million by 2012. That same amount would be worth just $500,000 if invested in the S&P 500.
The chart above was made using the information directly out of The Superinvestors of Graham-and-Doddsville, by Warren Buffett. The results date back to a group of 4 people who worked at the Graham-Newman Corporation between 1954-1956. Each was a disciple of Graham's value investing philosophy and went on to manage funds. Keep in mind, there wasn't thousands of workers, just 3 partners including Graham and the 4 "peasants", as Buffett describes themselves. Each colored bar represents one of their funds and the average annual compounded rate they earned while the gray bars represent the index being compared. Impressive!