To start understanding what value
investing really means, we 1st need to understand the true meaning
of investing.
Investing is the act of committing money or capital to an endeavour
(a business, project, real estate, etc.) with the expectation of obtaining an
additional income or profit. Investing also can include the amount of time you
put into the study of a prospective company, especially since time is money.
In words of
Benjamin Graham - Investing is "an operation which, upon thorough
analysis, promises safety of principal and a satisfactory return"
So to differentiate
investing from speculation you need the following:
1. Thorough
study of the business.
2. Expectation
of regular return or income.
3. Safety
of the invested capital or money.
Benjamin Graham
is considered the father of value investing. He began teaching the Value
Investing Concept at Columbia
Business School in 1928. The two of Grahams most known students are Warren
Buffet and Irving Kahn.
The Value Investing Concept has 5 fundamental rules.
Rule 1: Companies have intrinsic value
An intrinsic value is the true value of a business. A business's intrinsic value
could be estimated from its financial statements, namely the balance sheet and
income statement. This concept maybe explained with the help of a simple
example- Most sensible shoppers go to purchase a TV when its on sale rather
than purchasing it on full price. The quality or properties of a TV do not
change when its on sale. They remain same. The similar assumption holds true
for a stock. The prices of a stock may change even when the true value of the
company remains the same. The fluctuations in the market change the price but
they do not change what a buyer purchases.
The various methods one can
use to find the approximate intrinsic value of a company are- asset
based approach, cash flow based approach, study of prior transactions and
relative valuation of the company. But be warned, the intrinsic value that you
may arrive on may not always be true as any estimate of the intrinsic value is
based on a numerous assumptions about the future.
Rule 2: Always keep margin
of safety
When market
price is significantly below your estimation of the intrinsic
value, the difference is the margin of safety.
” A margin of
safety is achieved when securities are purchased at prices sufficiently below
underlying value to allow for human error, bad luck or extreme volatility” –
Seth Klarman
The future
is inherently unpredictable, thus a margin of safety provides protection
against bad luck, human error or bad timing.
The margin
of safety concept may be explained better with the following example:
If you were asked to build a
bridge over which 10,000-pound trucks were to pass, would you build it to hold
exactly 10,000 pounds? Of course not, you’d build the bridge to hold 15,000 or
20,000 pounds. That is your margin of safety.
Rule 3: Consider the Efficient Market
Hypothesis wrong
The efficient market hypothesis or EMH states that it is
impossible to beat the market. It assumes that all stocks trade at a fair price
on the stock exchange. Thus making the purchase of undervalued stocks and sale of
inflated value stocks, difficult.
Value investors believe that sometimes stocks are under-priced
or over-priced.
Rule 4:
Value investors do not follow the others
Value
investors are often considered contrarians. They go against the crowd. Value investors not only
reject the efficient-market hypothesis, but when everyone else is buying,
they're often selling or standing back. When everyone else is selling, they're
buying or holding.
Value investors do not
consider buying the popular stocks as they are usually over-priced. They look at companies which are usually
unloved, neglected and typically cheap but not low in quality.
Rule 5: Have patience and
diligence
To become a value investor
it is necessary to know your circle of competence. To enhance ones circle of
competence one should do what he knows. One should do his/her research well.
Value investors never get compelled to invest in an area because everyone else
is investing there.
The circle of competence of
a person enhances over a period of time. Unlike sportspersons, investors get
better as they age.
[1]
Definition of investing as per www.investopedia.com
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