You may call it Warren Buffet style of investing as he is the one who made it popular, but everyone loves and praise this style of equity investments but the majority do not practice it. Simply because of one big reason: It is opposite of normal human emotions. Humans are indeed emotional and hence they depict very different kind of emotions when it comes to investing. They fall into the trap of bad choices, they believe in false advice, they are impatient, they loose cool, they change style frequently, they are extra vigil and they bow down to peer pressure. Exactly opposite of what Value Investing proposes.
The essence of value investing is to buy a stock or an asset at a value less than its intrinsic value (the correct or justified valuation). So this means you need a method a process to know what is the actual value of an asset and what the value should be?
So is it all mathematics?
Yes, a part of as it involves auditing the firms/companies documents. It involves ratio analysis to compare sales, revenues, expenditures expenses over many years. It also needs the application of forecasting models to know future trends. One also needs to use valuation techniques like DCF or Discounted Cash Flow (Hey if you do not understand DCF right now, no problems, we will understand it some other time). But with numbers its quality assessment too.
Someone once asked Warren Buffett how to become a better investor. He pointed to a stack of annual reports. “Read 500 pages like this every day,” he said. “That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.”
Warren Buffet says just look for 3 things – a great business (sustainable, everlasting brands and uniqueness), good fundamentals (low debt, PB ratio) and a management with integrity (most important).
So, if a stock or investment qualified the above 3 requirements and is available at a right price (as per calculation using value-based investing), it’s a goldmine to buy.
Value investing as a concept is appreciated by almost all people who deal in volatile investments like shares or mutual funds. Be it large investors, mutual fund managers, hedge fund managers, pension fund managers or large corporates like Berkshire Hathway.
But in practice, only a few people have been able to apply the concept with success. The most important reason for failure were:
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- Identification process of the value company was faulty.
- Management changed and company could not keep up its good work.
- Investor Behaviour: Investor makes an exit too soon or could not keep his nerves during turbulent times and bowed before his own mind or management he was reporting to.
Some really cool facts about Value Investing:
- Value investing as a concept was elaborated first by Benjamin Graham & David Dodd, both professor at Columbia University, in 1934. They authored a book Security Analysis and spoke about this concept for the first time.
- In Graham’s book The Intelligent Investor, he advocated the important concept of margin of safety — first introduced in Security Analysis, which calls for a cautious approach to investing.
- One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Now Modern technique like DCF is also used widely.
- A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984, speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation (a trading firm set by Graham. Buffet also worked their initially) and were thus most influenced by Benjamin Graham.
- Aside from Buffett, many of Graham’s other students, such as William J. Ruane, Irving Kahn, and Charles Brandes have gone on to become successful investors in their own right.
- Seth Klarman, founder and president of The Baupost Group, a Boston-based private investment partnership, authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. (the book is out of print)
- Value Investing is not for Share and Stock only. The principals can be applied to Mutuals Fund Investing, Real Estate, and Pension products also. In fact, Warren Buffet told about his 2 real estate investments some time ago.
- Value Investing does not mean identifying few gems (make a concentrated portfolio) and sit tight. It advocates proper diversification.
- Value investors don’t buy the most popular stocks of the day (because they’re will be overpriced), but they are willing to wait and invest in companies that aren’t household names if the financials are right.
- Value investors don’t believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account. Value investors believe that sometimes stocks are underpriced or overpriced.A stock might be underpriced because the economy is performing poorly and investors are panicking and selling all their stocks (think recession of 2008-12). Or it might be overpriced because investors have gotten overly excited about a new technology that hasn’t proven itself yet (think dot-com bubble of 2001).
I have been reading about Value Investing for about 4 years now, and without any shame, I would say that finally, it has started sinking in me. It took long because, I had to unlearn a lot to absorb this, but it was worth. The books I mentioned about value investing are very difficult reads but finally, after constant endeavors, they are talking to me now. I will keep sharing what I have learned in the most readable and easy manner I can.
Share your mind and do let me know what you think?