Value investing is the strategy of investing in stocks trading at a discount from their underlying value. It has a long history of delivering above-average with limited downside risk. The fundamentals of value investing are crucial to its philosophy and process. Here are six that form the foundation:
- Don’t lose money
- Stay within your circle of competence
- Invest with a margin of safety
- Make large, concentrated bets
- Think like a business owner
- Invest in yourself
We will dive deeper into each principle below.
1. Don’t lose money
Rule #1 of the fundamentals of value investing is don’t lose money. It may seem like an obvious comment, but it refers to the investor’s mindset. Don’t go into investment thinking that it is ok to lose the principal. Don’t sell the stock if it goes down. If you bought a stock based on some hot tip, you would not have the mental resilience to ride any volatility. By thoroughly researching and understanding the company you invested in, you can be confident that the stock will go back up over time. In some ways, the essential quality of an investor is their temperament, not how intelligent they are. They don’t care what the crowd is doing or if the market is down but commits to a long-term view of investing.
You have to be comfortable for a stock to go down 50% or more after purchasing it. Just because a stock goes down 50% does not mean a great company is any less great. If you know what you bought is quality, you are more likely to stick with it.
2. Stay within your circle of competence
To have an edge in investing, you have to think about the things where you have an advantage over other people. It is no use working in an area where others a smart and you are stupid. Focus on areas where you know a lot, and stay within your circle of competence. The size of the circle is not important; it is knowing where the boundary is. This helps you avoid problems and identify opportunities. Investors need to be able to select businesses, not be an expert on every company. This doesn’t mean you do not stop learning; quite the contrary. You should be continually working on expanding your circle of competence by being a life-long learner. You should chip away at the edges by learning something new every day.
Anybody can diversify using an index fund, but the trick of the game is to have a handful of time when you know a company is better than average and invest where you have that insight. For example, you may work in real estate and be able to accurately value every piece of commercial real estate in your neighborhood. You will know when a particular property is undervalued or how much a property will be worth once it is fixed up. By exploiting these market inefficiencies, you can amass great wealth over a long period. Or take a doctor who specializes in diabetes; they will know first-hand how effective each available diabetes drug on the market is at treating diabetes. Over time they will paint a clear picture in their mind of which companies continuously innovate and release better and better products and which ones are lagging.
3. Invest with a margin of safety
Value investors’ primary goal is not to lose money. To help prevent a permanent loss of capital, investors look for a margin of safety that allows room for bad luck, imprecision, or analytical error to mitigate any significant losses. Valuing a company is not an exact science, and the future is unpredictable. The value investing philosophy is buying stocks at a substantial discount from their underlying value and holding them until the market recognizes their actual value. This requires a lot of patience and discipline. One hundred investment opportunities can come by, some with small gaps between price and value and some with very wide gaps, but you only have to grab an opportunity when it makes sense. Often the investor has to analyze many potential investments before finding one that has a sufficient margin of safety. The fundamentals of value investing is to buy a dollar for fifty cents essentially.
4. Make large, concentrated bets.
Diversification is probably the most repeated mantra in the investment world. This is not incorrect for people who do not have the time or patience to study each company carefully they are investing in. Dollar-cost averaging into an index fund is the best way for most people to invest in the market with very little thought. However, if you want to beat the market, you have to do something that does not follow the crowd. Using your circle of competence and investing with a margin of safety makes it possible to have above-average returns.
For example, Berkshire Hathaway has two-thirds of its value in 3 stocks- Apple, Bank of America, and American Express (Apple making up 45% of the total portfolio). If you know that a handful of companies are likely to succeed over the long term and are the best investments you could make compared to other options, why not put a large percentage of your wealth into them? Putting your money on the next best idea is settling for the second best. It is not going to benefit you in the long run.
5. Think like a business owner
It is important to remember that stocks represent tiny pieces of a company. They are not just numbers moving up and down on a screen. When buying a stock, you technically become a part-owner of a business but without the responsibility of the day-to-day running of that business. This business owner mentality is what investors should adopt when buying a stock. This focuses the mind on the longer-term trajectory of the company and avoids making off-the-cuff investment decisions. Business owners analyze decisions more deeply and are more cautious when making those decisions.
Before investing, it is essential to understand the economic prospects of the business, the management, and the price that makes sense. It would help if you also were comfortable with the idea of the stock market closing for ten years after you purchase. If you are confident it is a good business and will increase its intrinsic value over the long term, this should not bother you. This is vital to the fundamentals of value investing.
6. Invest in yourself
This may sound cliché, but the most valuable investment you can make is in yourself by far. Being able to communicate your ideas effectively will help you live up to your potential, whether this is through writing, speaking to individuals, or public speaking. If you are an expert on something, you have to be able to clearly show other people you are an expert so that your value can be recognized. One of the best things you can do is be exceptionally good at something. People will give you something of value in exchange for what value you can bring. And whatever abilities you have cannot be taxed or taken away from you.
