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Basics of Value Investing

Value investing is an investing style pioneered in the early 1920s at Columbia Business School by Benjamin Graham and David Dodd. Until then, stock market investing was driven mainly by speculation and insider information. Graham, who is known as the father of value investing, sums up the crux of value investing in his classic work The Intelligent Investor:

    An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Graham began teaching his value investing approach at Columbia Business School in 1928. Two decades later, Warren Buffett enrolled for the course. He mastered the value investing approach and went on to become the richest investor ever. Here's what he says about value investing:

    The basic ideas of investing are to look at stocks as business, use the market's fluctuations to your advantage, and seek a margin of safety. That's what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.

Buffett's glorious investing journey started from the basics of value investing.

We believe you too can start your investing journey here...from the very basics.

Value Investing, in Simple Words

Value investing is an investment approach that seeks to profit from identifying undervalued stocks. It is based on the idea that each stock has an intrinsic value, i.e. what it is truly worth.

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Through fundamental analysis of a company, we can determine what this intrinsic value is. The idea is to buy stocks that trade at a significant discount to their intrinsic values (i.e. they are cheaper than their true value). Once we buy an undervalued stock, the stock price eventually rises towards its intrinsic value, and makes a profit for us in the process.

Value investing is conceptually simple, though requires effort to implement. Research process focuses on finding out the intrinsic value of a company. Primary tool for researching a company is called fundamental analysis.

The Philosophy of Value Investing

Benjamin Graham- the founder of Value Investing introduced four components that define the philosophy behind value investing.

Let us look at each one of them in detail...

  • First Component: Mr. Market

    Imagine you are in a partnership with Mr. Market, where you can buy or sell shares. Each day, Mr. Market offers you prices for shares depending on his mood. If Mr. Market is in a very optimistic mood, he will offer very high prices. In this case, an investor should cash out of shares. If Mr. Market is in a very pessimistic mood, he will offer low prices, and this is the time to buy.
  • Second Component: Intrinsic Value

    Intrinsic value represents the true value of the company based on fundamentals. In the short term, market prices deviate from their intrinsic values due to changing market sentiments. In the long term, market prices return to intrinsic values. This process allows us to make profits, because we can buy stocks when they fall below their intrinsic values. We then hold them until they return to their intrinsic values in the long term.
  • Third Component: Margin of Safety

    "A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." - Seth Klarman

    The margin of safety is the essence of valuation. Since the estimates of intrinsic value involve subjective assessments, there is a possibility of being overly optimistic. Margin of safety provides cushion by adjusting the optimism from the forecast. Say, for example, your estimate of intrinsic value is Rs 100. Taking into consideration a margin of safety of 20%, you can adjust the value to Rs 80. This will ensure that you do not overpay for any asset.
  • Fourth Component: Investment Horizon

    "In the short run, the market is a voting machine but in the long run it is a weighing machine." - Benjamin Graham

    Value investing works in the long term, because that is when prices return to their intrinsic value. Value investing does not aim to predict what stock prices will do 2 days or 2 months from now. Instead, it aims to pick undervalued businesses that will outperform in the long term. This will eventually reflect in the stock price.

Evolution of Value Investing

Value investing started as a purely quantitative approach that has now evolved to incorporate a qualitative approach.

Benjamin Graham's view was that one only needed to look at the financial statements of a company in order to determine its value. There was no need to analyze qualitative factors such as a company's management, future product offerings, etc. The numbers told the investor everything they needed to know about whether they should invest in a company or not. This approach is known as the cigar butt approach. The advantage of the quantitative approach is that it is based on hard facts alone. The analysis is objective, and less reliant on assumptions.

Unfortunately, the quantitative approach does not account for all the factors that determine a company's true value.

Qualitative factors such as the management quality, industry dynamics, competition, future products, consumer behavior, etc. are all relevant to a company's performance. Warren Buffet's approach incorporated these qualitative factors into his analysis, along with the quantitative factors.

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Warren Buffet's Four Filter Approach to Value Investing

Warren Buffet's four filter approach is an evolved version to value investing. It is process by which one can arrive at an investment decision while keeping both, the qualitative as well as quantitative factors of value investing. It has four steps and identifies companies by:

Step 1: Identifying Circle of Competence

This comprises all the businesses that you are familiar with and thoroughly understand. For value investors, it is important to invest only in businesses that they understand. Value investors must focus solely on areas of business where they believe they have an edge over the average investor.

Likewise, staying away from what you don't understand is equally important.

Step 2: A Moat to Protect Your Castle

If we look at the castles, there is a deep moat all around. This moat was typically filled with water and crocodiles or other predatory reptiles to keep the attackers/enemies away. In value investing too, you should look to protect your castle.

In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage, wider is the moat. This moat would protect the business from competition. And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in.

Companies that have a wide moat are able to earn higher returns for its shareholders. And it is able to do so consistently year after year, every year. This in turn propels its projected stock value.

Step 3. Able and Trustworthy Management

Perhaps among various factors that need to be looked at before investing in a company, the management is the most important.

Able and trustworthy management means that management consistently demonstrates competence and works in the interest of shareholders.

There are three main factors in assessing management:

  1. The results of the company
  2. The treatment of the company's shareholders
  3. How well it allocates capital

Step 4. A Sensible Price Tag

Finally, a sensible price tag for stock selection is nothing more than having a margin of safety that we discussed earlier. It consists of valuing the company's true market value per share by various valuation methods.

So those were the steps on how one can go about value investing and make big money in the stock markets. Happy investing!

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