I have been in the world of investing for years now. One phrase I often come across is “value investing”.
If you ask a real practitioner of value investing, she will say “it is all there is to investing”. Investing cannot be anything else but based on value.
I cannot disagree.
Hence, I have been trying to learn and understand, what is value investing?
Is it a school of thought, an investing paradigm or a strategy?
What makes some of the greatest investors of all times, such as Warren Buffett, followers of its principles?
Let’s find out.
What is value investing?
As I read through text after text – online or offline – books, magazines, etc. one reference that kept coming up was of “The Intelligent Investor”.
Authored by Benjamin Graham, this book has come to be known as an investing classic. It is said to hold the timeless principles of investing. The same principles have come to be now known as value investing.
As you read and reread and yet re read (yes, that’s what you do with classics), some fundamental principles emerge.
Today, I am sharing with you those principles of value investing.
First, let’s understand what is an investment?
Graham writes in The Intelligent Investor –
“an investment operation is one which, upon thorough analysis promises safety of principal and adequate return. Operations not meeting these requirements are speculative.”
While you may be forgiven if you think that the above definition pertains to a fixed income instrument, it is not. This is about any investment, specially a investing in stocks.
We will see how.
Based on Graham’s definition of investing, it has 3 key elements:
#1 Thorough Analysis
When you buy a stock, you are not buying a piece of paper but an underlying share in a business that sells products/services, creates value and makes profits or losses.
You have to understand how the business does it and then do your own analysis to see if that business is worth your money. The concept that is used here is that of intrinsic value or measuring the real worth of the business.
Remember, this is different from the stock market price, which can be far apart from the real value.
#2 Safety of Principal
When you invest in a business it is subject to external economic and market influences as well as management and operational problems that can arise from time to time.
While you do a thorough analysis and determine a value of the business as also identify the risks, there is always the ‘unforeseen’ that can act against your interests.
The assumptions that you make about the future may not turn out as per your expectations. As a result, you may pay more for the business that it is worth. This can work against you and threaten the safety of your investment, your principal.
Graham has said that you must provide for the safety of the principal at all times.
To provide for these errors of judgement, the unforeseen and thus protect your principal, you have to provide for a margin of safety.
#3 Adequate return
As written by Benjamin Graham, a reasonable or adequate return is “any rate or amount, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.”
If as an individual investor, you seek to build your own portfolio of stocks, the return (net of costs), should exceed that from investing in an index fund or any other actively managed mutual fund.
This is a good benchmark to have for an adequate return. If you can’t do that for yourself, you are better off giving your money to the money managers.
Along with the 3 elements, there are 3 concepts that need one must understand and imbibe as an intelligent investor:
1. Intrinsic value
As a stock investor, intrinsic value helps you answer the question – “How much should I pay for this business?”
To succeed as an investor, you must be able to estimate a business’s worth and calculate its intrinsic value. This will help you avoid the big mistake of overpaying.
If you calculate the intrinsic value of a business as Rs. 100 (just counting the book value of its land, plant & machinery and the cash in the bank) and it is available to buy in the stock market for Rs. 90, it can be a worthy investment.
As per Graham, you can calculate an estimate of the intrinsic value of a business by using information from its financial statements such as balance sheet, profit and loss account and cash flow statement.
2. Mr Market
The market participants who buy and sell stocks are humans and they are subject to a corroding influence of emotions. They feel ecstatic at times and dejected at others. There is over optimism and greed at some times and fear and pessimism at others.
As a collective, these reactions are embedded in an entity called Mr Market.
Mr Market makes for an interesting person. Everyday he makes you an offer, a deal – buy at x price, sell at y price.
Since Mr Market is subject to emotional frenzies, these price offers are usually way off the mark from the real intrinsic worth of the businesses they represent.
Now you have a choice to either accept or reject Mr Market’s offers. It is important that you learn to take advantage of Mr Market.
The best part – Mr Market never feels bad. Whatever may be your decision and no matter how many times you make him suffer losses – he is back the next moment, the next hour, the next day willing to do fresh business with you.
Remember, you have to take advantage of Mr Market and not give in to his emotional pangs.
3. Margin of safety
We discussed in the “Safety of principal” that you ought to protect your investment. And for this you have to see that for your interest you always pay less than the intrinsic value of the business.
“How much less” will be your own assessment and judgement?
The margin of safety is the single most investing principle. Graham said that if he had to pick 3 most important words about investing, they will be “margin of safety”.
Here is an example:
If you have to build a bridge which has to allow cars and trucks amounting to 10,000 kgs to pass, you are better off building one which can actually hold 15000 kgs. That is margin of safety.
Can I do it?
The 3 key elements and the 3 concepts together form the foundation of investing or value investing, as it has come to be known as.
This might seem like a straightforward thing to do but it isn’t. As individuals, one thing that we fail to have is self control. Just like weather, we suffer from vagaries of emotions too.
The question I am thus asking is “can I do it”?
There are hundreds of businesses that present themselves as potential investment opportunities.
- How do I set myself up to thoroughly analyse and study businesses, study their annual reports and financial statements?
- How do I know if I am interpreting the financial information correctly and estimating the intrinsic value?
- How do I know that I am using a good enough margin of safety?
- What if I do all of the above and yet am not able to generate an acceptable rate of return?
- I am afraid I might start with all the enthusiasm of a new comer but it may soon vanish. What if I get caught into Mr Market’s mood swings and enrich him at my cost?
- Not just that I have been given to understand that investing requires a lot of patience, by the truckloads. Am I patient enough?
The above questions are real. If you want to succeed as an investor, you have to answer them for yourself.
So, what do I do?
Years ago, When I first posed these questions, the solution I opted was outsourcing. I hired specialists and gave them the job.
I hired fund managers to do investing for me.
You can too. In fact, you an do value investing with mutual funds.
Now, some of these fund names are obvious.
However, you should not fall for the names. Contra fund, dividend yield fund, value fund – there are all sorts of them.
Mind you there are some funds that may say they practise value investing, but reality could be different.
There are distinct characteristics of a value investor and a value investing driven mutual fund.
That is what we will find out in my new eGuide – Value Investing with Mutual Funds.
- Which are these funds?
- How do they go about practising value investing?
- What are their other features?
- Can you invest in them too?
The eGuide covers all this including the mutual funds that practice value investing – the good, the bad and the ugly.
Watch out for the premium eGUIDE on “Value investing with mutual funds.”
Meanwhile, what are your thoughts on value investing? How do you go about putting it into practise? Do share your views in the comments box.