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