The fundamentals of value investment have been time tested. Followers of the value philosophy such as Warren Buffett, Seth Klarman and Howard Marks have amassed billions of dollars in their lifetimes. In a nutshell, here are the basic tenets of value investing.
1. Shareholders as Business Partners
Value investors believe that buying a stock is comparable to buying a portion of the business. Thus, a value investor is not concerned about short-term changes in the stock price as much as the long-term business performance such as earnings growth, competitive positioning, etc. It’s similar to buying a farm: When you buy a corn farm, you don’t worry too much about the resale value of the farm, but you do worry about how much income you can earn from the harvest and the chances of drought in the area. Similarly, a value investor studies the value of the business rather than the movement of stock price charts.
2. Intrinsic Value
Returning to our farm example, we would value the corn farm based on the earning potential of the farm. For instance, it would be outrageous to pay $100,000 for 10 acres of farmland which has an earning potential of $100/acre after all the costs. It doesn’t matter if everyone else is willing to pay even more than $100,000 for the same piece of land. A value investor would simply call it a ‘corn mania’ and move onto other opportunities. Value investors may not necessarily follow the crowd. They are rather focused on the ‘intrinsic value’ of the asset, what the business is really worth—measured by its book value, earning potential and the probability of its sustainability.
3. Mr. Market
Benjamin Graham in his book the Intelligent Investor introduced the famous parable of Mr. Market. Every day, Mr. Market (for example, the S&P 500) offers a price for a security. As value investors, our job is to prudently judge if the offer price is a bargain. In contrast to other investors, the happiest moment for value investors would be when Mr. Markets offers a huge discount. It happened during 2008—not a bad year for a value investor! It was a time to go for discount shopping. On the other hand, when Mr. Market is all pumped up, he prices his goods at an outrageously high price. It is to be noted that there is no obligation from our side to accept what Mr. Market offers. We can simply ignore him at euphoric times, and our disciplined approach would protect us from downside risk.
4. When to Sell?
Warren Buffett famously said that his favorite holding period is forever! A value investor does not prophesize when the market will realize its intrinsic price. However, the value investor accepts that at some point in the future, the market will realize its intrinsic value—it could be in a month or five years. When the value investor realizes that Mr. Market is willing to buy his stock at a premium, he will sell and invest in another bargain stock.
5. Margin of Safety
Margin of Safety is the famous term coined by Ben Graham in Security Analysis. In simple terms, an asset worth $100 and bought at $80 has a better Margin of Safety than the same asset bought at $95. Seth Klarman, in his book Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor, says “value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.” The Margin of Safety is critical for a value investor to avoid losses at the time of market downturn.