Value investing was made famous by the world's most successful share investor, Warren Buffet.A strategic approach to buying shares of value and holding them for the long term, value investing was fiirst espoused by Benjamin Graham and by his legendary, ultra-successful student Warren Buffet. It's a philosophy that equates share ownership to 'buying' part of a business.
It sounds simple on the surface: find a company of value, buy its shares when the price is low relative to its worth, and hold on for the long term. Yet although value investing is not overly complex and doesn't use intricate formulas and graphs, it's often misrepresented and misunderstood. Many articles and guides to this style of investing skip or misconstrue the main message: value is separate to price, and value can only be truly determined by knowing the business whose shares you are buying.
Know thy business
'Valuing a business is part art and part science,' Buffet once said. It's an observation which displays the elusiveness of intrinsic value and what it takes to determine it. Value must not be confused with price. Price is what someone is prepared to pay, and is not necessarily an accurate indicator of underlying net worth. For example, just because a former high-flying stock is selling for half-price doesn't mean it's good value. The stock may have much further to fall and may never recover. Without knowing its intrinsic value, you can't know if a low price is good value or not.
Buffet says that as investors we must know the business whose stock we are buying, which means we have to do our homework. In order to determine value we must be knowledgeable on aspects of the business which could impact its ability (or inability) to produce future earnings.
Reading annual reports of the company we are looking into, and its competitors, may not be as glamorous as hearing about a hot tip over a cafe on a Saturday morning, but it makes a lot more sense. And when it comes to share investing, as Buffet has commented, unfortunately the straightforward approach is often overlooked by many: 'I have seen no trend toward value investing in the 35 years I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.'
Rational thinking is at the heart of value investing: 'Investment is most intelligent when it is most businesslike.' These nine words from Graham have been proclaimed by Buffet to be the most important ever published on investment. Taking the viewpoint of owning part of a business gives us an entirely different perspective to other investors, separating us from the pack-driven mentality that is abound in the stock market. Our focus remains firmly fixed on the real business issues, rather than on the daily price quotations.
'Money grows on the tree of patience.'
It's been said that the share market is a mechanism that transfers wealth from the impatient to the patient. Indeed, knowing when to buy is an important part of investing. Understanding value, however, is the key to success in the share market, according to Buffet. Mastering this concept, knowing the worth of a company and it's potential for future earnings, then allows you to judge whether the price is below its worth, making it a good buy.
In it for the long haul
The consumption of goods and services is the key driver of business earnings, and over time, these earnings increase. A good business will retain part of its profits. Over the longer term, on average, the business assets available to quality businesses grow. Eventually, in spite of short-term price volatility, the value and eventually, the price of the business will reflect the growing business assets.
The dividends from quality businesses on average, slowly but surely trend upward, in spite of short-term share price volatility. The short term, when it comes to the price of quality businesses, is 10 years, not three to five as some people would think. This makes the medium term 20 to 30 years and the long term, quite simply, your lifespan.
Understanding this can help us become long-term strategic thinkers and value investors, rather than simply being active market players over the short term. And when we begin to invest long-term, we begin to think long-term. All the market hype, which has little bearing on our investment outcomes, becomes far less relevant.
Rather than thinking in terms of absolute end returns and dollar value goals, we need to think in terms of continuous efficient capital management, year in and year out. For example, the compound effects of an investment held over the long term are far greater than an investment held for only a few years. Plus, a long-term perspective allows us to ride out market fluctuations, and avoid paying unnecessary fees and capital gains taxes.
Fluctuations in the market do not make us wealthier or poorer. Only changes in a business? intrinsic value can actually do that. As value investors we minimise risk by looking at the worst case first, choosing investments with a built-in margin of safety. For example, before you try and look at how much a share will make, try to avoid losses. Knowing the value of a business puts us in a position where we are able to decide when its share purchase price is in fact a bargain.
The nature of businesses and retained earnings (which we'll speak more about in upcoming posts) means that every year longer that we own shares, the likelihood that they will be worth more than we paid for them increases, and the risk decreases.
Value investing is all about long-term strategic investing, rather than making quick, frequent decisions about where to invest your capital. Buffett, in particular, espouses that you need have only a handful of good ideas or perhaps just one in a lifetime, to achieve real wealth. He advises limiting your stock selections to perhaps just one a year, or even less, and then, when you have found a superlative idea, to add to your holdings in it and hold it for the very long term. As he says, 'Our favourite holding period is forever.'
Dos and Don'ts of Value Investing
Do view share investing as business ownership.
Don't mistake price for value.
Do read as much about the business as possible; annual reports are the best source of information.
Don't overlook competitors - you need to research them too in order to assess future earnings properly.
Do take advantage of market fluctuations to buy bargains
Don't become preoccupied with the day to day movements of the market
Do allow for a margin of safety - buy at a big enough discount to allow some room for error in your estimation of value.
Do select a small number of businesses to thoroughly research in a few chosen industries.
Don't try and become an expert on every business under the sun, in every sector