Background to Value Investing
Serious value investors do not like the term “value investing”. They rather 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, again by Benjamin Graham). It is not exactly clear how this term caught up. But best definition of value investing is that it is investing based on the principles laid down by Benjamin Graham, and made popular by that legendary investor, Warren Buffett.
The two most fundamental concepts of value investing (according to Mr Warren 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 stock markets. So let’s dwell on them one by one.
Mr. Market is a persona given to the entire stock market. Think of 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 next hour. Apparently these people make money by second-guessing.
According to Benjamin Graham and Warren Buffett, and all value investors who subscribe to this thinking, money cannot be made by such hyper active 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- like where to allocate capital, which business to acquire, which subsidiary 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 investor puts 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 slightly ridiculous. For example, the value of an Asian company that generates sufficient cash from its own operations and all of whose clients are also companies which are self sufficient in Asia and the same company does not need any external funding for many years (either debt or equity) should not be affected by a sub-prime crisis like situation in a distant market like USA. But the price of the Asian company is likely to tank along with the other indices in the world. Rationally, the price of Asian company should not fall, but it will most likely not escape the negative sentiment pervading in the market. And 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 a 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 one in Finance 101 classes to the complicated models used by Wall Street quants) 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. Think of a simplest business that is a small wheat farm. Wheat is a commodity; price of one wheat farmer does not vary much from the other farmer. Yet you cannot know for sure where the wheat market will be 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 price and yield based on historical data. You can possibly say that I am 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 to you at a price that is substantially less than the most pessimistic estimate of value, you buy that company.
Technical Analysis vs. Value Investing
If you subscribe to 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 to 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 current of water, temperature of lake. He is hoping that he will be able to predict correctly how, when and where the fishes would 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 wait. He is free to do other things with the spare time he has – for example play some classical music in the background, call his old pals from high school. His serenity is that of an old wise owl.
The choice is yours – which sort of fisherman do you want to be?Recommend0 recommendationsPublished in