Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
4 simple steps to Value Investing: Step 1 - Views on News from Equitymaster
  • E-MAIL
  • A  A  A
  • Apr 17, 2013

    4 simple steps to Value Investing: Step 1

    We all know value investing as the art of buying stocks trading at a discount to its intrinsic value. But how does the entire process work? How should one go about choosing the right kind of stocks and then eventually calculate its intrinsic value. Fortunately for us, the entire process has been broken down in four simple steps by none other than one of the most famous practitioners of this art, Warren Buffett.

    And what exactly are these steps? Well, let us discuss them one by a one in a series of four articles to be published over the next couple of weeks. Ok, so here comes the first of the four steps.

    Circle of competence

    What is your mental image of Warren Buffett? Or for that matter any great value investor? Do you imagine them as all-knowing number-crunching machines? Do you think of them as extraordinary supermen who have an in-depth understanding of everything in the world of business? If you did have these impressions about them, then you are grossly mistaken!

    What is the secret to their investing success then, you may ask? The answer is, knowing your 'circle of competence', as Buffett likes to call it. Your 'circle of competence' would comprise all the businesses that you are familiar with and thoroughly understand.

    Investing in what you understand

    A value investor must focus solely on areas of business where he believes he has an edge over the average investor. Say you're a doctor. Being an insider to the healthcare industry, you would most likely have a pretty good first-hand understanding of the sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other hand, would not have access to this valuable information. This puts you in a position of advantage. Of course, this does not mean you are already an expert on pharma stocks. But you are at a great starting position.

    Similarly, many products and services that you use in your daily lives are often listed companies. As a regular consumer and visitor to the mall, you may have a good starting knowledge about product quality, pricing and competitors.

    Some of Warren Buffett's major investments have been companies with whose products he has been familiar since his childhood. At the early age of 6 years, Buffett went door to door selling Coca-Cola cans and Wrigley's chewing gum. When he was in high school, he made money by delivering newspapers. As we know, these companies later became some of his major investments.

    Staying away from what you don't understand

    Investing in what you know is one thing. But there is another very important aspect which is often ignored. And this is where the likes of Buffett have a significant edge over others. Great investors have a very clear understanding of what they do not know.

    Buffett is known to be quite disciplined as far as staying within the 'circle of competence' is concerned. He avoids businesses whose dynamics he does not understand well. When everyone on Wall Street was going gaga over internet and technology stocks in the late 1990s, he stood his ground and didn't invest a single penny in them. He openly admitted that he did not understand the sector. Simple...

    This brings us to another very useful insight. Great familiarity may not always result in great understanding. Buffett has been a long-time friend of Bill Gates, the billionaire founder of Microsoft. He held the techie genius in very high regard and admired him for his management acumen. While he donated a significant part of his wealth to Bill & Melinda Gates Foundation, he never invested in Microsoft.

    The reason has been simple. He did not know that industry very well. He could not clearly envision what the business would be like 5 to 10 years later. As such, he was willing to let go of a seemingly great investment opportunity. It is this discipline that has made him one of the world's richest investor.

    To conclude, here is an interesting quote by Charlie Munger which summarises, in a nutshell, the whole essence about staying within your 'circle of competence': "Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly."

    4 simple steps to Value Investing - Next article | All Articles
    Try the Warren Buffett Quiz

      Ankit Shah (Research Analyst) is the editor for Equitymaster Insider and Vivek Kaul's Inner Circle. A journalism graduate turned Research Analyst, Ankit joined Equitymaster when he was just 23 years old, right after getting his MBA from NMIMS, Mumbai. Having been an avid reader of Equitymaster's research through his college years, Ankit knew he would fit right in!

    In his seven years with Equitymsater, Ankit rose quickly, leaving his mark on almost everything from: Travelling thousands of miles to find the next small cap stock, as part of the Hidden Treasure team... Designing Equitymaster's Secrets, an online value investing course based on the company's 20-year journey... Bringing global investing ideas to Indian readers through Vivek Kaul's Inner Circle... Right to launching his brand-new service, Equitymaster Insider.

    Ankit is a firm believer in Charlie Munger's multidisciplinary approach on juggling between various disciplines...He is not just a research analyst, but also a voracious reader and an avid traveler...Born and brought up in Mumbai, he now prefers to keep away from the noisy megapolis as much as possible. In any given month, you could find him exploring the ancient ruins of South America, the beaches of South East Asia, or the organic cafes of Pondicherry.



    Equitymaster requests your view! Post a comment on "4 simple steps to Value Investing: Step 1". Click here!

    1 Responses to "4 simple steps to Value Investing: Step 1"

    ram dhamne

    Aug 15, 2013

    i just want to invest

    Equitymaster requests your view! Post a comment on "4 simple steps to Value Investing: Step 1". Click here!

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    You've Heard of Timeless Books... Ever Heard of Timeless Stocks? (The 5 Minute Wrapup)

    Aug 19, 2017

    Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms


    Aug 18, 2017 (Close)