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What is Value Investing and how it works?
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What do such big-time investors – movers and shakers on Wall Street – like Warren Buffet, Walter Schloss, Irving Kahn, Mario Gabelli, and Joel Greenblatt all have in common? They have successfully used an investment paradigm known as value investing successfully to help grow their wealth.
Perhaps as a novice investor, you have heard the term “value investing” thrown around from time-to-time and have little or no clue what it means.
Value investing refers to a set of doctrines that were introduced by Ben Graham in his 1934 book, Security Analysis. At its core, value investing involves buying up stock that is not currently in favor due on the market due to irrationality on the part of investors. Extreme investor irrationality can many times push the price of a stock far below the true value of the stock. If a value investor takes advantage of these stocks, he can end up seeing quite a return on his investment when the market begins to look at the stock in a different light and its value goes up. Thus, the term value investing, in layman’s terms, simply means investing in stocks that have been de-valued based on unfounded reasons by a market filled with illogical or otherwise unreasonable investors.
As billionaire Warren Buffet once said, “Follow Graham, and you will profit from folly rather than participate in it”. Warren Buffet, who built a fortune by following Graham’s principles, is thought to be Graham’s most famous and successful “student”.
Principles of Value Investing
The value investing mindset is underpinned by several key concepts and principles that are paramount to Graham’s philosophy. A couple of principles actually stand out more than others. The first of these is that a value investor will invariably take on the perspective of the business owner when analyzing a company’s potential. And secondly, a value investor will nearly always count on short term irrationality in the market. After these two precepts have been established during an evaluation of the so-called out of favor stock purchase, then the value investor will follow an additional principle to determine a margin of safety and intrinsic value.
In a nutshell, the key principles that are associated with value investing and value investors include:
Approaching the stock valuation as if you are the owner of the business. Value investors must imagine themselves as if they own the business themselves. (And after all, when you purchase stock in the business, you will be, in de facto, an owner of the issuing company or business, even if you own one share).
Pay homage to the fact that the market has beat down the price of the stock in an unfounded and irrational way. The price of the stock really does not have a relation to its real worth or its net value as an asset. The two are far removed from each other.
Make a determination of the intrinsic value of the stock. Graham defined this intrinsic value as the discounted value of all of the stock’s future distributions. This can be wide ranging, and is typically just an estimate since calculating the intrinsic value cannot be an exact calculation and there is no formula for doing so.
Determining the margin of safety for the purchase. The discount of the market price of the stock to the stock’s intrinsic value is what Graham referred to as the margin of safety. Value investors should evaluate the stock efficiently to determine if the stock is undervalued sufficiently enough to weather any market downturns and uncertainties. A decision is then made to determine if the stock is a worthwhile purchase and a good investment.
Related article: Best brokerages for long-term investors in 2012
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