“The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”                 Warren Buffett

What exactly is value investing?

Most people have the opinion that value investing is buying cheap stocks – those that are trading at low price to earnings or low price to book value. I am not surprised that some people even think that value investing is buying low-priced stocks, those penny stocks selling for a few cents.

Icon8888, a regular contributor in i3investor in his most recent article mentioned that,

“Value Investing, best represented by Warren Buffett, advocates buying stocks that have moat. They aim for compounded growth over an extended period of time.”

And he uses return on invested capital (ROIC) as a quantitative measure of moat, which I think is quite right is a certain aspect, although there are a whole lot of other qualitative measures.

But his statement is far from truth in the perspective of a true value investor, in my opinion.

What did Buffett actually say about value investing?

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett 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 labelled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”

“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes 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, even if they appear in combination, are far from determinative as to whether 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.”

So it’s the ‘processes of picking up bargain stocks that value investing is all about. It is not as simplistic as some investors think. You must know what you are getting into.

Charlie Munger, Berkshire Hathaway’s Vice Chairman, who has influenced Buffet in purchase of Coca Cola and other seemingly high price acquisitions mentioned it out clearly.

“All intelligent investing is value investing - acquiring more than you are paying for. You must value the business in order to value the stock.”  

Munger explained further,

“You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”

So, value investing is intelligent investing. Value investing is about looking for a mispriced gamble, getting more than you are paying for. It is not just about buying cheap stocks. You must know enough about the business and hence the value the business. It is still a gamble, not a riskless endeavour, but by knowing the business and its value well enough, the probability of winning is higher.

Value investing is both a mind-set as well as a rigorous discipline.

Value investing focuses not only on how much money one can make from the market, knowing that everybody is trying to do that and hence it is not easy, but also avoid mistakes, resisting market fads, and hence the risks of losing with the investing motto of,

“Focus on the downside and the upside will take care of itself”        Mark Sellers

Value investing is not about buying companies with moat, with high ROIC at whatever price. It is about buying a company at a price way below its intrinsic value.

Value investing is considered as a marathon, with winners and losers identified over a period of several years, not days, weeks or months, although value investors may not keep investment for ten years or decades.

Value investors, though not necessary buying stock with moats and keep them for long-term, they aren’t traders too in my opinion. They don’t buy stocks just because of a company exhibits a quarter or two of fantastic earnings, disregarding the quality of those earnings are, the cyclical nature and the power of mean reversion of the business. They don’t sell just because the company has reduced profit because of a quarter or two, of the same reasons.

Origin of Value Investing

Value investing was first made known by Benjamin Graham as a set of tenets when he wrote Security Analysis in 1934. Fundamentally, value investing involves buying stocks that are out-of-favour in the market due to investor irrationality. This irrationality, in the extreme, can often push a stock’s price well below its true value. A shrewd value investor seeks to determine the true value of such stocks, thus taking advantage of this type of investor irrationality.
 

There are several key principles and concepts that underpin the value investing mind-set and are central to the philosophy espoused by Graham. Two principles in particular stand out: firstly, the value investor always takes take a business owner’s perspective when analysing a company. Secondly, the value investor always counts on the irrationality of the markets in the short term (Mr. Market). Once these two principles are established during the evaluation of an out-of-favour stock for purchase, the value investor must follow the additional principles of determining intrinsic value and a margin of safety.

In short, the key principles are:

1.      Price is not value

2.      Mr. Market is a crazy guy

3.      Every stock has an intrinsic value

4.      Only buy with a margin of safety

5.      Diversification is the only free lunch

Key Principle 1: Price is not value

The first key lesson for the would-be Value Investor is that the worth of a business is independent of the market price. A stock quote from day to day is only how much just the few shareholders who bother to trade that day decide their investment is worth. It is categorically not the worth of the entire company.

This is the reason share prices so often spike when being bid for by an acquirer, who generally has to pay something closer to fair value. Investors should understand that the share price is like the tip of an iceberg – you can see it, but you’ve no idea how big or small the iceberg is below the surface unless you put on your dive suit.

As Ben Graham observed: “price is what you pay, value is what you get”, meaning that big swings in the market don’t necessarily mean big swings in value. When you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity? As long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.

Key Principle 2: Mr. Market is a crazy guy

In Graham’s “The Intelligent Investor”, a book which is required reading for all new analysts at top investment firms, the author conjured his now infamous parable of Mr. Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr. Market. He’s a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis. But Mr. Market is something of a manic depressive whose quotes often bear no relation to the state of the underlying business – swinging from the wild enthusiasm of offering high prices to the pitiful gloom of valuing the company for a dime. As he explains, sometimes you may be happy sell out to him when he quotes you a crazily high price or happy to buy from him when his price is foolishly low. But the rest of the time, you will be wiser to form your own ideas about the value of your holdings, based on updates from the company about its operations and financial position.

Key Principle 3: Every stock has an intrinsic value

The critical knowledge an investor needs to take advantage of Mr. Market’s behavior and inefficient prices is an understanding of the true value of a business. The true value of a business is known as its ‘intrinsic’ value and is difficult, though not impossible, to ascertain.

Most investors preoccupy themselves with measures of ‘relative’ value which compare a valuation ratio for the company (perhaps the price-to- earnings, price-to-book or price-to-sales ratio) with its industry peer group or the market as a whole. Inevitably though, something that appears to be relatively cheap on that basis can still be overvalued in an absolute sense, and that’s bad news for the Value Investor who prefers to tie his sense of value to a mast in stormy waters.

 Intrinsic valuation looks to measure a company on its economics, assets and earnings independently of other factors. But be warned, establishing an intrinsic valuation is not straightforward and there are multiple, contradictory ways of calculating it. 

Key Principle 4:  Only buy with a margin of safety

When Warren Buffett describes a phrase as the “three most important words in investing” every investor owes it to himself to understand what it is. The words “Margin of Safety” come from the writing and teachings of Graham and have ensured that his followers have prospered in many market environments. But what does it mean and why is having a large margin of safety so important?

Seth Klarman, one of the modern era’s greatest Value Investors, defines a margin of safety as being “achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility.”

In other words, once you are certain that you have a fair estimate of a share’s intrinsic value you must only buy the share when you are offered a price at such a discount to that  value that  you are safe  from all unknowns. The difference between the market price and the intrinsic value is the margin of safety. As Buffett once opined:

“You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”

Valuation is an imprecise art and the future is inherently unpredictable. Having a large margin of safety provides protection against bad luck, bad timing, or error in judgment. Given that the investor is using his own judgment, the technique introduces a cushion against capital loss caused by miscalculations or unpredictable market movements (i.e. the value of the stock falls further).

Opinions are divided on how large the discount needs to be to qualify the stock as a potential ‘buy’. Indeed, the bad news is that no-one really agrees on this – for two reasons. First, as we have already discussed, determining a company’s intrinsic value is highly subjective. Second, investors are prepared to be exposed to different levels of risk on a stock by stock basis, depending on how familiar they are with the company, its story and its management.

In his writings, Graham noted that: “the margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price”. He suggested looking for a margin of safety in some circumstances of up to 50% but more typically he would look for 33%.

Key Principle 5: Diversification is the only free lunch

Diversification is incredibly simple to understand and plainly common sense – you shouldn’t put all your eggs in one basket – but in practice (like everything that is supposed to be simple) it seems to be extremely difficult to pull off. The majority of individual investors are massively under-diversified, often with an average portfolio size of only a few stocks, stocks in the same industry, the same theme.

The value investing camp splits into two on this topic. Fundamental value hunters who follow Warren Buffett tend to fall into the ‘focus portfolio’ camp believing that you should put all your eggs in just a few baskets and watch them like a hawk. While it may be true that 71% of the benefits of diversification do come from the first five stocks in a portfolio, this kind of attitude requires a great gift for security analysis and is particularly risky given the high exposure to stock specific disasters – the kinds that value stocks are prone to.

Bear in mind, there is only one Warren Buffett in this world, and he is right because he is Warren (Walter Schloss)

 An alternative approach is that espoused by the more ‘quantitative’ value farmers who seek to ‘harvest’ the value premium from the market. Knowing the world can be uncertain, most value investors hold diversified portfolios acknowledging that they could be wrong in their analysis and judgment. Generating superior return is certainly an important aim, but safeguarding our assets and protecting them from losses is just as crucial. In that sense, diversification is a natural course of action.

In his deep value strategies Graham recommended owning a portfolio of 30 bargain stocks to minimize the impact of single stocks falling into bankruptcy or distress, while Joel Greenblatt recommends a similar level of diversification when following his Magic Formula strategy.

Making sense of value investing principles

We have discussed how it was good news for individual investors that making money using a value investing strategy requires the mastery of just a few principles. What should be clear now is that while intrinsic value and margin of safety make perfect sense in the context of value stock selection, defining precisely how to execute each principle requires some careful thinking and the acceptance that some nuances can only be decided by the interpretation and preference of each investor.

As usual, the final words here are for those who wish to embark on fundamental value investing to build long-term wealth, please contact me for an online investment course for a small fee at

ckc13invest@gmail.com

Here I would like to add another principle in fundamental value investing,

Tis goeth down to a fundamental aspect that “An investment in knowledge pays the best interest”            - Benjamin Franklin

K C Chong