People often ask what is value investing. Many are curious how one of the world’s richest man, Warren Buffett can accumulate his wealth for many decades in a consistent manner. A simple answer to what is value investing is simply the strategy of acquiring stocks at a huge discount to their intrinsic value. Intrinsic value of stocks can be derived via fundamental analysis without referring to the market value.
This value investing approach will require the investor to adopt a contrarian mindset for a long term perspective. A stock can fall in price below its intrinsic value due to different reasons such as short term profit warning. This makes it attractive enough for value investors like us to buy and hold it until a set profit target is met.
The impact of short term profits falls on long term value of a business is often small. Hence, value investors understand that value investing is not always in favour and does not always outperform over shorter time periods. As proven over the last 100 years, adopting value investing strategy has a consistent history of outperforming index returns across multiple equity markets.
What Warren Buffett say about Value Investing
Different articles define what is value investing differently. Some say value investing is the investment philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios and have high dividend yields. Others say value investing is all about buying stocks with low P/E ratios. You will even sometimes hear that value investing has more to do with the balance sheet than the income statement.
In Warren Buffett’s 1992 letter to Berkshire Hathaway shareholders, he wrote:
“We think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”
The term ‘value investing’ is widely used. Typically, it means the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics may not determine if an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. On the contrary, a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are also in no way inconsistent with a ‘value’ purchase.”
Warren Buffett’s definition of “what is value investing” is the purchasing a stock for less than its calculated value.
Knowing What Is Value Investing
1) Own a share in the underlying business.
A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business.
2) Intrinsic Value of Stock.
You may derive a stock’s intrinsic value from the economic value of the underlying business.
3) Stock market is inefficient.
Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. Value investors widely reference from his Mr. Market metaphor even today:
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”
4) Treat Investing As A Business
Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught. Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession.
5) Margin of Safety
A true investment requires a margin of safety. A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is manifested in the difference between the quoted price and the intrinsic value. It absorbs all the damage caused by the investor’s inevitable miscalculations. This margin of safety must be as wide as possible, say at least a 25% off the market price.
What Value Investing Is Not
Value investing is purchasing a stock for less than its calculated value. Surprisingly, this fact alone separates value investing from most other investment philosophies.
Long-term growth investors focus solely on the value of the business. They do not concern themselves with the price paid as they only wish to buy shares in extra-ordinary businesses. They believe that the phenomenal growth such businesses will experience over a great many years. This allows them to benefit from the wonders of compounding.
Some so-called value investors do consider relative prices. They make decisions based on how the market is valuing other public companies in the same industry and how the market is valuing each dollar of earnings present in all businesses. They may choose to purchase a stock simply because it appears cheap relative to its peers, or because it is trading at a lower P/E ratio than the general market. This is not value investing.
Value investing requires the calculation of an intrinsic value that is independent of the market price. Techniques that are supported solely (or primarily) on an empirical basis are not part of value investing. True value investing requires no more than basic math skills.
In conclusion, you may define value investing as paying less for a stock than its calculated value. The intrinsic value of the stock is truly independent of the stock market. One can calculate intrinsic value using an analysis of discounted future cash flows or of asset values. This strategy have proven quite effective in the past, and will likely continue to work well in the future.
You can not be a value investor unless you are willing to calculate business values. To be a value investor, you just have to value the business.
Sign up now for a free value investing singapore seminar package (worth S$349) to learn what is value investing and how this can be done in a smarter way.
Fundamental Analysis Lesson #1