If you had given $10,000 to Warren Buffet in 1956 that investment would now be worth over $400 million, and that’s after fees and taxes. Much of Buffet’s success is owed to his chosen investment philosophy, that of value investing. This article provides an introduction to the value investing philosophy and outlines its core principles.
Widely considered the most successful investor of the 20th century, Warren Buffet is among the world’s richest people. He is also the primary shareholder, chairman and CEO of Berkshire Hathaway, a company that has delivered an average annual growth rate of 20.3% to its shareholders for the last 44 years. From 2000 to 2010, Berkshire Hathaway stock produced a total return of 76% versus a negative 11.3% return for the S&P 500.
Buffet learned the value investing philosophy from his mentor, the legendary Wall Street analyst and father of value investing Benjamin Graham.
Graham is author of two of the most influential books in the investing world: Security Analysis which he wrote with David Dodd in 1934, and The Intelligent Investor which was published in 1949. The Intelligent Investor is a book Warren Buffett described as “by far the best book on investing ever written” and both books are still considered must-reading for any serious investor.
In short, Graham’s goal was to buy a dollar’s worth of assets for $0.50 and he did so very successfully. Though details of Graham’s investments are not readily available it is said that he averaged around a 20% annual return through his many years of managing money. He achieved these results at a time when buying common stocks was widely regarded as a pure gamble.
Value investing refers to a particular philosophy that drives the way an investor approaches buying a company. Value investors believe that the irrationality of market participants leads to variations in the price of a stock (sometimes to extremes) but that a stock that is undervalued will eventually reach its true value over time.
Value investors focus on identifying and purchasing these undervalued stocks by looking at the businesses themselves and their fundamentals. Put simply, value investing involves calculating the intrinsic value of a business i.e. working out what it’s really worth, and then purchasing its equity at a discount to that intrinsic value.
Value investing does not mean buying poor quality companies just because they trade at a low multiple of book value or earnings. In fact, most successful value investors own high quality stable companies but look to buy them when they are out of favour for whatever reason.
The two core principles at the heart of value investing are intrinsic value and margin of safety.
The intrinsic value is the true value of the business should you wish to buy the whole company for cash. I.e. what a company would be worth to a private owner independent of the stock market. In determining the intrinsic value of a business investors following a value approach often ask questions that come under three headings:
- Circle of Competence: Do I understand this company/ industry? Can I make reasonable projections about its future? Is it within my circle of competence?
- Company Evaluation: Is it a good business? Does it have a sustainable competitive advantage? Does it have a high return on capital? Does it have decent growth? A healthy balance sheet? Strong free cash flow? Is this a good industry?
- Management Evaluation: Do they run the business well? Are they good at allocating capital?
Determining the intrinsic value of a business is not an exact science, it is therefore expressed as a range and not a precise number.
Margin of safety
If all the above criteria are met, one crucial question remains: Is the stock trading at a big discount to intrinsic value? In other words if I buy the stock at today’s price is there a big margin of safety?
Margin of safety represents the gap between the current market price and the intrinsic value of the company or asset in question. A safety margin of at least 20% is desirable. The concept of a margin of safety was introduced by Graham and Dodd in the book Security Analysis.
“If it’s close, we don’t play.” Ben Graham.
You don’t need to be a genius to be a value investor, it merely requires an understanding of a few basic principles that anyone can master. Why value investing isn’t more widely followed today probably has to do with the fact that today’s market participants want more “action” and want instant gratification.
To quote Christopher Browne author of The Little Book of Value Investing “Value investing is like watching the grass grow, it’s not very exciting”. In fact, patience is an important aspect of value investing: as Warren Buffett is quoted as saying “If a business does well, the stock eventually follows” however you will often have to be content with being “wrong” until such time as the market sees what you see and revalues your company accordingly.
In value investing you are betting against the market (the herd) and so you are looking for the rare situations when you are right and the market is wrong. This contrarian approach to investing takes a great deal of conviction which usually only comes from doing a great deal of research and establishing an ‘informational edge’ over other market participants looking at the same stocks, and often the same data.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.”
Phil Fisher, author of Common Stocks and Uncommon Profits.
At the heart of the value investing methodology is the concept of margin of safety and in today’s volatile markets I would argue that having a margin of safety is more important than ever. What I find puzzling is that more investors don’t adopt the value investing approach, certainly the success of investors such as Warren Buffet, Peter Lynch, Irving Kahn, Michael Price, and Roger Montgomery, speaks for itself.