What is Value Investing?
Warren Buffet defined value investing in the 1977 Berkshire Hathaway annual letter to shareholders: “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”
Fifteen years later in the 1992 annual letter to the shareholders of Berkshire Hathaway Inc., he added, “We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” Since most of us aren’t the size of Berkshire Hathaway let’s continue to use “very attractive price”.
Does it Work?
Transitory factors can create a large disparity between intrinsic value (true worth) and a company’s stock price but the intrinsic value is eventually recognized in the marketplace over time. The short answer is yes, value investing works. Warren Buffett is probably the best know of a long list of successful value investors.
Can a method from 1934 be applicable today? In a Case for Valuing Investing the evidence is clear: Three sources with empirical data make a compelling case for value investing.
How do you go about it?
Warren Buffett, the Oracle of Omaha, amassed a fortune from astute investments through his company Berkshire Hathaway. Berkshire Hathaway has outperformed the stock market for decades and investors all over the world study Buffett’s investment approach and ideas for insight. Some of this insight is outlined in his 12 principles for buying a business.
When you buy stock you are buying a piece of a business; that seems obvious. But it is not often the way people think about investing. To others day trading and investing seem like the same thing but they are not. Having the right perspective is the difference between winning and losing. Read more in: Buy a Business not a Stock.
We have been taught that a high rate of return requires that we take greater risks and the way to manage that risk is diversification. This is flat wrong and detrimental to our wealth. The answers are at the heart of value investing and come from some of the most successful investors in the world. Risk, investor discipline, and the three tenets of value investing.
Look for the most compelling values by searching, reading profusely, following known value experts for ideas and then do your own analysis to estimate intrinsic value. Buy the best opportunities selling at large discounts regardless of size. By being patient and acting like an owner of the company, over time when business prospects improve or intrinsic value is recognized, the market place will narrow the valuation gap. Monitor the company continuously to determine progress or needed changes to the investment thesis.
Each investment opportunity is unique so one size does not fit all, but these guidelines should always be part of the value investing approach:
1. Rule number one: avoid permanent loss of capital.
2. Focus on pockets of market inefficiency.
3. Seek to invest in companies that:
Offer significant appreciation potential to intrinsic value.
With strong fundamental prospects.
A catalyst to improve prospects with time.
That meets Warren Buffett’s investment principles.
4. Identify opportunities where the intrinsic value is calculable within my circle of competence.
5. Invest in companies where the market price is preferably at least 50% below intrinsic value.
6. Certain “Core Value” companies may be purchased at market prices at least 30% below intrinsic value.
7. Cash is a byproduct of investment opportunities and an alternative to permanent capital loss.
The specific fundamental value investing criteria used by most value investors and described in “What Has Worked In Investing” are:
1. Low price in relation to asset value: Stocks priced at less than book value are purchased on the assumption that, in time, their market price will reflect at least their stated book value; i.e., what the company itself has paid for its own assets.
2. Low price in relation to earnings: Stocks bought at low price to earnings ratios afford higher earnings yields than stocks bought at higher price to earnings. The earnings yield is the yield which shareholders would receive if all the earnings were paid out as a dividend. Benjamin Graham recommended investing in companies whose earnings ield was 200% of the yield on AAA bonds….To paraphrase Warren Buffett, “value” and “growth” are joined at the hip. A company priced low in relation to earnings, whose earnings are expected to grow, is preferable to a similarly priced company whose earnings are not expected to grow. Price is the key. Included within this broad low price in relation to earnings category are high dividend yields and low prices in relation to cash flow (earnings plus depreciation expense).
3. A significant pattern of purchases by one or more insiders (officers and directors): Officers, directors and large shareholders often buy their own company’s stock when it is depressed in relation to the current value which would be ascribable to the company’s assets or its ongoing business in a corporate acquisition…insiders often have “insight information”…knowledge…which they believe will result in an increase in the true underlying value of the company.
4. A significant decline in a stock’s price: A decline in price is often accompanied by a decline in earnings or an earnings disappointment. Reversion to the mean is almost a law of nature with respect to company performance.
5. Small market capitalization: …Most publicly traded companies are small in terms of their market capitalization. Furthermore, these companies are often associated with higher rates of growth and may, due to their size, be more easily acquired by other corporations.