Serious value investors do not like the term “value investing”. They prefer intelligent investing, referring to the second most important book in value investing, “The Intelligent Investor” by Benjamin Graham (the most important being Security Analysis, also by Graham).
It is not exactly clear how this term caught on. But the best definition of value investing is that it involves investing based on the principles laid down by Benjamin Graham, and made popular by legendary investor, Warren Buffett.
The two most fundamental concepts of value investing, according to Buffett himself, are Mr Market and Margin of Safety.
According to Buffett, if any investor can actually internalise these two concepts, he or she will never fare poorly in the stock market. So let’s dwell on these one by one.
Mr Market is a persona given to the entire stock market. Think of the stock market as a salesman. He is quoting different prices for buying a tiny fraction of ownership in leading companies of the economy. The prices keep running on ticker tapes, websites and television screens.
The prices he quotes keep changing rapidly. These rapid changes make interacting with stock markets a very exciting proposition.
There are lots of people who keep second guessing what the price is going to be. Some are guessing what the price will be by the end of day, some are guessing what the price will be in the next hour. Apparently these people make money by second-guessing.
According to Graham and Buffett, and all value investors who subscribe to this thinking, money cannot be made by such hyperactive second-guessing. Such guessing is speculation. Investing is something else.
If you think about it, the price of a company changes very rapidly, but the value of the company changes slowly.
The value of the company is dependent on certain choices that management make – such as where to allocate capital, which businesses to acquire, which subsidiaries to sell, how many units to lay-off.
The sum total of these choices represents the current state of affairs of the business to which investors put a value and the market puts a price.
How value investing works
Intelligent investing is all about buying a stock when the gap between investors’ estimate of value and Mr Market’s estimate of price is so huge, that it is almost ridiculous.
For example, the value of an Asian company that generates sufficient cash from its own operations and all of whose clients are also self-sufficient companies in Asia, will not be affected by a sub-prime crisis such as in a distant market like the US.
They will also not be affected if the same company does not require any external funding for many years (either debt or equity).
But the price of the Asian company is likely to tank along with other indices in the world. Rationally, the price of the Asian company should not fall, but it will most likely not escape the negative sentiments pervading in the market.
This situation presents an interesting buying opportunity for the value investor.
Margin of safety
The ridiculous gap between value and price gives the value investor a “margin of safety”. It frees him from second-guessing what the price will be shortly.
It also frees him from putting a precise value on a company. It is very hard to estimate the value of a company accurately. In fact it cannot be done.
To understand why it cannot be done, we have to explain valuation very briefly. All valuation methodologies (from the simplest in Finance 101 classes to the complicated models used by Wall Street’s quantitative analysts) consist of three steps:
• Projecting the future cash flows that the business will generate
• Discounting them at an appropriate rate
• Finally, adding them up to arrive at a valuation number.
There is lot of uncertainty in projecting future cash flows. Let’s take a simple business – a small wheat farm.
Wheat is a commodity; one wheat farmer’s price does not vary much from the other. Yet, you cannot know for sure where the wheat market will be in the future. You cannot even know the yield for sure since the climate is always unpredictable.
If you cannot accurately forecast the cash flows from such a simple business, what chance is there to precisely predict the cash flows of a complicated business enterprise?
You can however, give a range of prices and yields based on historical data. You can possibly say that you are 99% sure that the farm will generate this much cash flow.
You can also generate such estimates for complicated business enterprises and when Mr Market is selling such enterprises at a price that is substantially less than the most pessimistic estimate of value, you buy that company.
Technical analysis versus value investing
If you subscribe to the value investing philosophy, there is no need to bother with any of the technical charts peddled by many firms employed by Mr Market. All those chartists guess where the price would be shortly. It is an entirely different approach.
To compare the two methods let us use the analogy of fishing. If a technical chartist goes fishing, he would carry multiple types of fishing rods with him. He would keenly observe all the fishes in the lake. He will have advanced tools with him to predict the water current and lake temperature. He is hoping that he will be able to predict correctly how, when and where the fishes will show up. His intensity is like that of a squirrel.
On the other hand a value investor would carry one simple fishing rod. He is only interested in a particular breed of fish and he knows that his rod can catch it. He puts the rod in its proper place, sits in a meditation pose and waits. He is free to do other things with his spare time – for example, play classical music in the background, call his old pals from school. His serenity is that of an old, wise owl.
The choice is yours – which sort of fisherman do you want to be?
This article first appeared in thenewsavvy.com
The New Savvy is Asia’s leading financial, investments and career platform for women. Our bold vision is to empower 100 million women to achieve financial happiness. We deliver high-quality content through conferences, e-learning platforms, personal finance apps and e-commerce stores.