There are many approaches to investing. Some may suit the risk-takers and get-rich-quick crowd, while others take a more conservative approach. Value investing attracts its own peculiar crowd with an almost cult-like following of the approach. Here we will look at the value investing philosophy and why there is such an avid following.
The value investing philosophy centers around purchasing assets at a discount to their intrinsic value, also known as buying with a margin of safety. It requires a great deal of discipline and patience to find these bargains, as well as thinking like a business owner and a long-term outlook.
Value investing philosophy overview
Value investing is a philosophy first outlined by Benjamin Graham and made famous by Warren Buffett. Value investing is about finding a bargain. The process uses a conservative analysis of a company’s underlying (intrinsic) value. It requires a great deal of discipline and patience to only buy when the shares are trading at a sufficient discount from that value. Investors perform an analysis of a company’s fundamentals (the information that gives the investor an idea of a company’s financial valuation) to try and determine a company’s value. Investors may look at hundreds of investment opportunities before finding a suitable bargain.
Much persistence is needed as value is often hidden, and the investor may need to dig down into a company to find it. This practice makes the strategy risk-averse as you are much less likely to overpay for a company. This discipline can mean standing apart from the crowd and going against the market’s consensus. The goal is to find companies whose value is not widely recognized by the market, buy its stock, and then wait for the market to recognize its intrinsic value. As a result, the investor may experience below-average returns in the short term, yet over the long run, experience above-average returns. Sticking to the philosophy is critical.
Waiting for the right investment
The great thing about investing is that it does not require you to reach a quota of investments for a given year. You can look at 10’s or even 100’s of companies before finding one that you deem suitable for purchase. The opportunity has to be just right; a great company that the investor can understand at a great price and is better than any other opportunity they can find. Warren Buffett calls this waiting for the right pitch (like in baseball). When attractive opportunities are abundant, such as a stock market crash, the investor must find the most attractive one. When opportunities are rare, such as in an extended bull market, the investor must exercise great patience and wait for an opportunity to come. An investor may only find one good opportunity a year, or they may find ten.
The subjectivity of business valuation
Not all information is available to the investor, and even if all present information is known, there are unforeseen outcomes in the future that cannot be accurately predicted. This makes valuing a business less of exact science and more of an art form. This uncertainty means that the investor does not know precisely what the company is buying. However, they can make educated guesses based on extensive research. There is also qualitative information that investors can have a difference of opinion on. For example, how does one investor consider the track record of management decisions? For example, one investor may think the CEO’s decision to expand overseas is a great strategy, whereas another investor may see it too risky. As a result, two investors can come up with two different valuations for the same company.
Buying with a margin of safety
As mentioned above, the goal of value investing is to buy a dollar for fifty cents. This means you are getting more value than what you paid, but it also provides a buffer for valuation mistakes and, therefore, less likely to experience loss. Because valuation has a certain level of impreciseness, investors need a margin of safety. It is similar to an elevator; the elevator may be able to carry 2,000 lbs., but you only want to have it take a maximum of 1,000 lbs. to ensure you are well within its tolerances. This is a vital element to the value investing philosophy.
When valuing a company, it is much easier to value tangible assets, such as property, plant, and equipment, because they have a market to value them. If a company owns warehouses and knows the price per square foot that warehouses are selling at, we can accurately calculate their value. However, compared to intangible assets, such as trademarks, patents, and intellectual property, it is much harder to value them. That is why value investors emphasize tangible asses when valuing a company.
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 company ownership is also the mentality that investors should adopt when buying a stock. In the same way, a farmer does not think about selling their farm one day in the hopes of repurchasing it next week at a profit; the investor should be a long-term owner. It would help if you also were comfortable with the idea of the stock market closing for twenty years immediately after your purchase. If you are confident the business will increase its intrinsic value over the long term, this holding period should not bother you.
The investor’s circle of competence
To have an edge in investing, you have to think about the areas 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 process is not essential; knowing where the boundary is. This awareness helps you avoid problems and identify opportunities. This doesn’t mean you do not stop learning; quite the contrary. It would help if you continually were working on expanding your circle of competence by being a life-long learner by chipping away at the edges of the circle by learning something new every day.
