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What is Value Investing?

Copyright  Â©  2006  Geoff  Gannon
What  Value  Investing  Is  Not
What  is  Value  Investing?
Value investing is purchasing a stock for
Different sources define value investingless than its calculated value. Surprisingly,
differently. Some say value investing is thethis fact alone separates value investing
investment philosophy that favors thefrom  most  other  investment  philosophies.
purchase of stocks that are currently selling
at low price-to-book ratios and have highTrue (long-term) growth investors such as
dividend yields. Others say value investingPhil Fisher focus solely on the value of the
is all about buying stocks with low P/Ebusiness. They do not concern themselves with
ratios. You will even sometimes hear thatthe price paid, because they only wish to buy
value investing has more to do with theshares 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 Hathawayexperience 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' isfast enough, and the stock is held long
redundant. What is 'investing' if it is notenough, even a seemingly lofty price will
the act of seeking value at least sufficienteventually  be  justified.
to justify the amount paid? Consciously
paying more for a stock than its calculatedSome so-called value investors do consider
value - in the hope that it can soon be soldrelative prices. They make decisions based on
for a still-higher price - should be labeledhow the market is valuing other public
speculation (which is neither illegal,companies in the same industry and how the
immoral nor - in our view - financiallymarket 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 'valuebecause it appears cheap relative to its
investing' is widely used. Typically, itpeers, or because it is trading at a lower P
connotes the purchase of stocks havingE ratio than the general market, even though
attributes such as a low ratio of price tothe P/E ratio may not appear particularly low
book value, a low price-earnings ratio, or ain  absolute  or  historical  terms.
high dividend yield. Unfortunately, such
characteristics, even if they appear inShould such an approach be called value
combination, are far from determinative as toinvesting? I don't think so. It may be a
whether an investor is indeed buyingperfectly valid investment philosophy, but it
something for what it is worth and isis  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 - aan intrinsic value that is independent of the
high ratio of price to book value, a highmarket price. Techniques that are supported
price-earnings ratio, and a low dividendsolely (or primarily) on an empirical basis
yield - are in no way inconsistent with aare 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 theof  a  logical  edifice.
best definition of value investing there is.
Value investing is purchasing a stock forAlthough 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  Investinglogical. Correct reasoning is stressed over
verifiable hypotheses; and causal
1) Each share of stock is an ownershiprelationships are stressed over correlative
interest in the underlying business. A stockrelationships. Value investing may be
is not simply a piece of paper that can bequantitative; 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 topervasive) distinction between quantitative
receive future cash distributions from thefields of study that employ calculus and
business. Economically, each share is anquantitative fields of study that remain
undivided interest in all corporate assetspurely arithmetical. Value investing treats
(both tangible and intangible) - and ought tosecurity 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'smathematical abilities than most security
intrinsic value is derived from the economicanalysts, 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. Valuemore  than  basic  math  skills.
investors do not subscribe to the Efficient
Market Hypothesis. They believe sharesContrarian investing is sometimes thought of
frequently trade hands at prices above oras 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 awho call themselves contrarian investors tend
share and the intrinsic value of that shareto  buy  very  similar  stocks.
is wide enough to permit profitable
investments. Benjamin Graham, the father ofLet's consider the case of David Dreman,
value investing, explained the stock market'sauthor 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 valuehis 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 youthe value investor from the contrarian
own a small share that cost you $1,000. Oneinvestor is fuzzy at best. Dreman's
of your partners, named Mr. Market, is verycontrarian investing strategies are derived
obliging indeed. Every day he tells you whatfrom three measures: price to earnings, price
he thinks your interest is worth andto cash flow, and price to book value. These
furthermore offers either to buy you out orsame measures are closely associated with
sell you an additional interest on thatvalue investing and especially so-called
basis. Sometimes his idea of value appearsGraham and Dodd investing (a form of value
plausible and justified by businessinvesting 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 iscalculated value, where the method used to
most businesslike. This is a quote fromcalculate 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 mostintrinsic value is calculated using an
important investing lesson he was everanalysis of discounted future cash flows or
taught. Investors ought to treat investingof asset values, the resulting intrinsic
with the seriousness and studiousness theyvalue estimate is independent of the stock
treat their chosen profession. An investormarket. But, a strategy that is based on
should treat the shares he buys and sells assimply buying stocks that trade at low
a shopkeeper would treat the merchandise heprice-to-earnings, price-to-book, and
deals in. He must not make commitments whereprice-to-cash flow multiples relative to
his knowledge of the "merchandise" isother 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 anycontinue  to  work  well  in  the  future.
investment operation unless "a reliable
calculation shows that it has a fair chanceThe 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 ofresemble those constructed by true value
safety. A margin of safety may be provided byinvestors. However, Joel Greenblatt's magic
a firm's working capital position, pastformula does not attempt to calculate the
earnings performance, land assets, economicvalue of the stocks purchased. So, while the
goodwill, or (most commonly) a combination ofmagic formula may be effective, it isn't true
some or all of the above. The margin ofvalue investing. Joel Greenblatt is himself a
safety is manifested in the differencevalue investor, because he does calculate the
between the quoted price and the intrinsicintrinsic value of the stocks he buys.
value of the business. It absorbs all theGreenblatt wrote "The Little Book That Beats
damage caused by the investor's inevitableThe Market" for an audience of investors that
miscalculations. For this reason, the marginlacked either the ability or the inclination
of safety must be as wide as we humans areto  value  businesses.
stupid (which is to say it ought to be a
veritable chasm). Buying dollar bills forYou can not be a value investor unless you
ninety-five cents only works if you know whatare willing to calculate business values. To
you're doing; buying dollar bills forbe a value investor, you don't have to value
forty-five cents is likely to provethe business precisely - but, you do have to
profitable  even  for  mere  mortals like us.value the business.



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