| Copyright © 2006 Geoff Gannon | | | | for less than its calculated value. |
| What is Value Investing? | | | | Surprisingly, this fact alone separates |
| Different sources define value investing | | | | value investing from most other |
| differently. Some say value investing is | | | | investment philosophies. |
| the investment philosophy that favors | | | | True (long-term) growth investors such |
| the purchase of stocks that are | | | | as Phil Fisher focus solely on the value |
| currently selling at low price-to-book | | | | of the business. They do not concern |
| ratios and have high dividend yields. | | | | themselves with the price paid, because |
| Others say value investing is all about | | | | they only wish to buy shares in |
| buying stocks with low P/E ratios. You | | | | businesses that are truly extraordinary. |
| will even sometimes hear that value | | | | They believe that the phenomenal growth |
| investing has more to do with the | | | | such businesses will experience over a |
| balance sheet than the income statement. | | | | great many years will allow them to |
| In his 1992 letter to Berkshire Hathaway | | | | benefit from the wonders of compounding. |
| shareholders, Warren Buffet wrote: | | | | If the business' value compounds fast |
| "We think the very term 'value | | | | enough, and the stock is held long |
| investing' is redundant. What is | | | | enough, even a seemingly lofty price |
| 'investing' if it is not the act of | | | | will eventually be justified. |
| seeking value at least sufficient to | | | | Some so-called value investors do |
| justify the amount paid? Consciously | | | | consider relative prices. They make |
| paying more for a stock than its | | | | decisions based on how the market is |
| calculated value - in the hope that it | | | | valuing other public companies in the |
| can soon be sold for a still-higher | | | | same industry and how the market is |
| price - should be labeled speculation | | | | valuing each dollar of earnings present |
| (which is neither illegal, immoral nor - | | | | in all businesses. In other words, they |
| in our view - financially fattening)." | | | | may choose to purchase a stock simply |
| "Whether appropriate or not, the term | | | | because it appears cheap relative to its |
| 'value investing' is widely used. | | | | peers, or because it is trading at a |
| Typically, it connotes the purchase of | | | | lower P/E ratio than the general market, |
| stocks having attributes such as a low | | | | even though the P/E ratio may not appear |
| ratio of price to book value, a low | | | | particularly low in absolute or |
| price-earnings ratio, or a high dividend | | | | historical terms. |
| yield. Unfortunately, such | | | | Should such an approach be called value |
| characteristics, even if they appear in | | | | investing? I don't think so. It may be a |
| combination, are far from determinative | | | | perfectly valid investment philosophy, |
| as to whether an investor is indeed | | | | but it is a different investment |
| buying something for what it is worth | | | | philosophy. |
| and is therefore truly operating on the | | | | Value investing requires the calculation |
| principle of obtaining value in his | | | | of an intrinsic value that is |
| investments. Correspondingly, opposite | | | | independent of the market price. |
| characteristics - a high ratio of price | | | | Techniques that are supported solely (or |
| to book value, a high price-earnings | | | | primarily) on an empirical basis are not |
| ratio, and a low dividend yield - are in | | | | part of value investing. The tenets set |
| no way inconsistent with a 'value' | | | | out by Graham and expanded by others |
| purchase." | | | | (such as Warren Buffett) form the |
| Buffett's definition of "investing" is | | | | foundation of a logical edifice. |
| the best definition of value investing | | | | Although there may be empirical support |
| there is. Value investing is purchasing | | | | for techniques within value investing, |
| a stock for less than its calculated | | | | Graham founded a school of thought that |
| value. | | | | is highly logical. Correct reasoning is |
| Tenets of Value Investing | | | | stressed over verifiable hypotheses; and |
| 1) Each share of stock is an ownership | | | | causal relationships are stressed over |
| interest in the underlying business. A | | | | correlative relationships. Value |
| stock is not simply a piece of paper | | | | investing may be quantitative; but, it |
| that can be sold at a higher price on | | | | is arithmetically quantitative. There is |
| some future date. Stocks represent more | | | | a clear (and pervasive) distinction |
| than just the right to receive future | | | | between quantitative fields of study |
| cash distributions from the business. | | | | that employ calculus and quantitative |
| Economically, each share is an undivided | | | | fields of study that remain purely |
| interest in all corporate assets (both | | | | arithmetical. Value investing treats |
| tangible and intangible) - and ought to | | | | security analysis as a purely |
| be valued as such. | | | | arithmetical field of study. Graham and |
| 2) A stock has an intrinsic value. A | | | | Buffett were both known for having |
| stock's intrinsic value is derived from | | | | stronger natural mathematical abilities |
| the economic value of the underlying | | | | than most security analysts, and yet |
| business. | | | | both men stated that the use of higher |
| 3) The stock market is inefficient. | | | | math in security analysis was a mistake. |
| Value investors do not subscribe to the | | | | True value investing requires no more |
| Efficient Market Hypothesis. They | | | | than basic math skills. |
| believe shares frequently trade hands at | | | | Contrarian investing is sometimes |
| prices above or below their intrinsic | | | | thought of as a value investing sect. In |
| values. Occasionally, the difference | | | | practice, those who call themselves |
| between the market price of a share and | | | | value investors and those who call |
| the intrinsic value of that share is | | | | themselves contrarian investors tend to |
| wide enough to permit profitable | | | | buy very similar stocks. |
| investments. Benjamin Graham, the father | | | | Let's consider the case of David Dreman, |
| of value investing, explained the stock | | | | author of "The Contrarian Investor". |
| market's inefficiency by employing a | | | | David Dreman is known as a contrarian |
| metaphor. His Mr. Market metaphor is | | | | investor. In his case, it is an |
| still referenced by value investors | | | | appropriate label, because of his keen |
| today: | | | | interest in behavioral finance. However, |
| "Imagine that in some private business | | | | in most cases, the line separating the |
| you own a small share that cost you | | | | value investor from the contrarian |
| $1,000. One of your partners, named Mr. | | | | investor is fuzzy at best. Dreman's |
| Market, is very obliging indeed. Every | | | | contrarian investing strategies are |
| day he tells you what he thinks your | | | | derived from three measures: price to |
| interest is worth and furthermore offers | | | | earnings, price to cash flow, and price |
| either to buy you out or sell you an | | | | to book value. These same measures are |
| additional interest on that basis. | | | | closely associated with value investing |
| Sometimes his idea of value appears | | | | and especially so-called Graham and Dodd |
| plausible and justified by business | | | | investing (a form of value investing |
| developments and prospects as you know | | | | named for Benjamin Graham and David |
| them. Often, on the other hand, Mr. | | | | Dodd, the co-authors of "Security |
| Market lets his enthusiasm or his fears | | | | Analysis"). |
| run away with him, and the value he | | | | Conclusions |
| proposes seems to you a little short of | | | | Ultimately, value investing can only be |
| silly." | | | | defined as paying less for a stock than |
| 4) Investing is most intelligent when it | | | | its calculated value, where the method |
| is most businesslike. This is a quote | | | | used to calculate the value of the stock |
| from Benjamin Graham's "The Intelligent | | | | is truly independent of the stock |
| Investor". Warren Buffett believes it is | | | | market. Where the intrinsic value is |
| the single most important investing | | | | calculated using an analysis of |
| lesson he was ever taught. Investors | | | | discounted future cash flows or of asset |
| ought to treat investing with the | | | | values, the resulting intrinsic value |
| seriousness and studiousness they treat | | | | estimate is independent of the stock |
| their chosen profession. An investor | | | | market. But, a strategy that is based on |
| should treat the shares he buys and | | | | simply buying stocks that trade at low |
| sells as a shopkeeper would treat the | | | | price-to-earnings, price-to-book, and |
| merchandise he deals in. He must not | | | | price-to-cash flow multiples relative to |
| make commitments where his knowledge of | | | | other stocks is not value investing. Of |
| the "merchandise" is inadequate. | | | | course, these very strategies have |
| Furthermore, he must not engage in any | | | | proven quite effective in the past, and |
| investment operation unless "a reliable | | | | will likely continue to work well in the |
| calculation shows that it has a fair | | | | future. |
| chance to yield a reasonable profit". | | | | The magic formula devised by Joel |
| 5) A true investment requires a margin | | | | Greenblatt is an example of one such |
| of safety. A margin of safety may be | | | | effective technique that will often |
| provided by a firm's working capital | | | | result in portfolios that resemble those |
| position, past earnings performance, | | | | constructed by true value investors. |
| land assets, economic goodwill, or (most | | | | However, Joel Greenblatt's magic formula |
| commonly) a combination of some or all | | | | does not attempt to calculate the value |
| of the above. The margin of safety is | | | | of the stocks purchased. So, while the |
| manifested in the difference between the | | | | magic formula may be effective, it isn't |
| quoted price and the intrinsic value of | | | | true value investing. Joel Greenblatt is |
| the business. It absorbs all the damage | | | | himself a value investor, because he |
| caused by the investor's inevitable | | | | does calculate the intrinsic value of |
| miscalculations. For this reason, the | | | | the stocks he buys. Greenblatt wrote |
| margin of safety must be as wide as we | | | | "The Little Book That Beats The Market" |
| humans are stupid (which is to say it | | | | for an audience of investors that lacked |
| ought to be a veritable chasm). Buying | | | | either the ability or the inclination to |
| dollar bills for ninety-five cents only | | | | value businesses. |
| works if you know what you're doing; | | | | You can not be a value investor unless |
| buying dollar bills for forty-five cents | | | | you are willing to calculate business |
| is likely to prove profitable even for | | | | values. To be a value investor, you |
| mere mortals like us. | | | | don't have to value the business |
| What Value Investing Is Not | | | | precisely - but, you do have to value |
| Value investing is purchasing a stock | | | | the business. |