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What is Value Investing?

Copyright © 2006 Geoff Gannonfor less than its calculated value.
What is Value Investing?Surprisingly, this fact alone separates
Different sources define value investingvalue investing from most other
differently. Some say value investing isinvestment philosophies.
the investment philosophy that favorsTrue (long-term) growth investors such
the purchase of stocks that areas Phil Fisher focus solely on the value
currently selling at low price-to-bookof the business. They do not concern
ratios and have high dividend yields.themselves with the price paid, because
Others say value investing is all aboutthey only wish to buy shares in
buying stocks with low P/E ratios. Youbusinesses that are truly extraordinary.
will even sometimes hear that valueThey believe that the phenomenal growth
investing has more to do with thesuch businesses will experience over a
balance sheet than the income statement.great many years will allow them to
In his 1992 letter to Berkshire Hathawaybenefit from the wonders of compounding.
shareholders, Warren Buffet wrote:If the business' value compounds fast
"We think the very term 'valueenough, and the stock is held long
investing' is redundant. What isenough, even a seemingly lofty price
'investing' if it is not the act ofwill eventually be justified.
seeking value at least sufficient toSome so-called value investors do
justify the amount paid? Consciouslyconsider relative prices. They make
paying more for a stock than itsdecisions based on how the market is
calculated value - in the hope that itvaluing other public companies in the
can soon be sold for a still-highersame industry and how the market is
price - should be labeled speculationvaluing 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 termbecause it appears cheap relative to its
'value investing' is widely used.peers, or because it is trading at a
Typically, it connotes the purchase oflower P/E ratio than the general market,
stocks having attributes such as a loweven though the P/E ratio may not appear
ratio of price to book value, a lowparticularly low in absolute or
price-earnings ratio, or a high dividendhistorical terms.
yield. Unfortunately, suchShould such an approach be called value
characteristics, even if they appear ininvesting? I don't think so. It may be a
combination, are far from determinativeperfectly valid investment philosophy,
as to whether an investor is indeedbut it is a different investment
buying something for what it is worthphilosophy.
and is therefore truly operating on theValue investing requires the calculation
principle of obtaining value in hisof an intrinsic value that is
investments. Correspondingly, oppositeindependent of the market price.
characteristics - a high ratio of priceTechniques that are supported solely (or
to book value, a high price-earningsprimarily) on an empirical basis are not
ratio, and a low dividend yield - are inpart 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" isfoundation of a logical edifice.
the best definition of value investingAlthough there may be empirical support
there is. Value investing is purchasingfor techniques within value investing,
a stock for less than its calculatedGraham founded a school of thought that
value.is highly logical. Correct reasoning is
Tenets of Value Investingstressed over verifiable hypotheses; and
1) Each share of stock is an ownershipcausal relationships are stressed over
interest in the underlying business. Acorrelative relationships. Value
stock is not simply a piece of paperinvesting may be quantitative; but, it
that can be sold at a higher price onis arithmetically quantitative. There is
some future date. Stocks represent morea clear (and pervasive) distinction
than just the right to receive futurebetween quantitative fields of study
cash distributions from the business.that employ calculus and quantitative
Economically, each share is an undividedfields of study that remain purely
interest in all corporate assets (botharithmetical. Value investing treats
tangible and intangible) - and ought tosecurity analysis as a purely
be valued as such.arithmetical field of study. Graham and
2) A stock has an intrinsic value. ABuffett were both known for having
stock's intrinsic value is derived fromstronger natural mathematical abilities
the economic value of the underlyingthan 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 theTrue value investing requires no more
Efficient Market Hypothesis. Theythan basic math skills.
believe shares frequently trade hands atContrarian investing is sometimes
prices above or below their intrinsicthought of as a value investing sect. In
values. Occasionally, the differencepractice, those who call themselves
between the market price of a share andvalue investors and those who call
the intrinsic value of that share isthemselves contrarian investors tend to
wide enough to permit profitablebuy very similar stocks.
investments. Benjamin Graham, the fatherLet's consider the case of David Dreman,
of value investing, explained the stockauthor of "The Contrarian Investor".
market's inefficiency by employing aDavid Dreman is known as a contrarian
metaphor. His Mr. Market metaphor isinvestor. In his case, it is an
still referenced by value investorsappropriate label, because of his keen
today:interest in behavioral finance. However,
"Imagine that in some private businessin most cases, the line separating the
you own a small share that cost youvalue investor from the contrarian
$1,000. One of your partners, named Mr.investor is fuzzy at best. Dreman's
Market, is very obliging indeed. Everycontrarian investing strategies are
day he tells you what he thinks yourderived from three measures: price to
interest is worth and furthermore offersearnings, price to cash flow, and price
either to buy you out or sell you anto book value. These same measures are
additional interest on that basis.closely associated with value investing
Sometimes his idea of value appearsand especially so-called Graham and Dodd
plausible and justified by businessinvesting (a form of value investing
developments and prospects as you knownamed for Benjamin Graham and David
them. Often, on the other hand, Mr.Dodd, the co-authors of "Security
Market lets his enthusiasm or his fearsAnalysis").
run away with him, and the value heConclusions
proposes seems to you a little short ofUltimately, value investing can only be
silly."defined as paying less for a stock than
4) Investing is most intelligent when itits calculated value, where the method
is most businesslike. This is a quoteused to calculate the value of the stock
from Benjamin Graham's "The Intelligentis truly independent of the stock
Investor". Warren Buffett believes it ismarket. Where the intrinsic value is
the single most important investingcalculated using an analysis of
lesson he was ever taught. Investorsdiscounted future cash flows or of asset
ought to treat investing with thevalues, the resulting intrinsic value
seriousness and studiousness they treatestimate is independent of the stock
their chosen profession. An investormarket. But, a strategy that is based on
should treat the shares he buys andsimply buying stocks that trade at low
sells as a shopkeeper would treat theprice-to-earnings, price-to-book, and
merchandise he deals in. He must notprice-to-cash flow multiples relative to
make commitments where his knowledge ofother stocks is not value investing. Of
the "merchandise" is inadequate.course, these very strategies have
Furthermore, he must not engage in anyproven quite effective in the past, and
investment operation unless "a reliablewill likely continue to work well in the
calculation shows that it has a fairfuture.
chance to yield a reasonable profit".The magic formula devised by Joel
5) A true investment requires a marginGreenblatt is an example of one such
of safety. A margin of safety may beeffective technique that will often
provided by a firm's working capitalresult in portfolios that resemble those
position, past earnings performance,constructed by true value investors.
land assets, economic goodwill, or (mostHowever, Joel Greenblatt's magic formula
commonly) a combination of some or alldoes not attempt to calculate the value
of the above. The margin of safety isof the stocks purchased. So, while the
manifested in the difference between themagic formula may be effective, it isn't
quoted price and the intrinsic value oftrue value investing. Joel Greenblatt is
the business. It absorbs all the damagehimself a value investor, because he
caused by the investor's inevitabledoes calculate the intrinsic value of
miscalculations. For this reason, thethe 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 itfor an audience of investors that lacked
ought to be a veritable chasm). Buyingeither the ability or the inclination to
dollar bills for ninety-five cents onlyvalue businesses.
works if you know what you're doing;You can not be a value investor unless
buying dollar bills for forty-five centsyou are willing to calculate business
is likely to prove profitable even forvalues. To be a value investor, you
mere mortals like us.don't have to value the business
What Value Investing Is Notprecisely - but, you do have to value
Value investing is purchasing a stockthe business.



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