The Principles of Value Investing

Value investing is an investing philosophy first developed by Benjamin Graham and David Dodd in the 1930s, which focuses on buying stocks whenever the market undervalues them. This investing method has been adopted by several investors over the past century and most of them have been able to beat the market, which is not something that easy to do, considering that most people lose money in the stock market.

The most famous and certainly most successful value investor known today is one of Ben Graham’s students, the famous Warren Buffett. Buffett is living proof that Value Investing works.  Since he has been practising this investment style, Warren Buffett’s return has been a staggering 20.3% and he has become one of the richest men alive.

Value Investing is a way of life

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

– Warren Buffett

When you go shopping for, let’s say, socks, the first thing that you are looking for is quality. You want the socks to be comfortable, to fit your feet and preferably, to last a long time. You also want these socks to be at a good price. But, if you find high-quality socks at a 50% markdown price, you’ve hit the jackpot. When it comes to shopping for stocks, the value investor will use the same principles: invest in high-quality growing companies at discount prices. In this article, I will highlight the main principles by which a value investor is guided.

The compounding magic

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

-Albert Einstein

The average trader thinks in absolute and “short-term” returns: “how much did I do today?” and not how much did I do in the past 10 years on average per year. Value investors care only about what they do on average for a period of many years. The average is the element X the number of years in which the asset was held that leads to the outcome of the compounding magic.

Legendary investor Warren Buffett understood that at an early age and the results speak for themselves. The following table compares the total percentage gain from Berkshire Hathaway’s performance with the S&P 500 over the last 55 years:

Berkshire’s Performance vs the S&P 500

This is not an error: the 10% difference from 1965-2019 would lead to an absolute 2.7 million percent vs a 19.8 thousand percent return. Seems like an easy task and it is, however, many fail to do it. The reason is that investors have no patience and want to make money here and now. There is no fast and quick money in the stock market and the person who tries to do so, will get the same results that a gambler gets in the casino over the long run. Therefore, patience is another feature that a successful value investor needs.

Here is a table that shows the outcome of the magic in different scenarios of $1,000 invested. You can see the importance of the average return, but, more than that, you can see the importance of the holding period of the investment.

Risk and Volatility

“Risk comes in not knowing what you’re doing”
– Warren Buffett 

For a value investor, risk is not associated with volatility. Risk is associated with the fundamentals of businesses. If the stock price of a company falls, and the fundamentals don’t change, it becomes less risky, not riskier. Therefore, it is important for you to do your homework, to understand these fundamentals very well, before making an investment so as to minimise the risk as much as possible.

Warren Buffett is known to read 500 pages a day and he says that knowledge is just like wealth: it compounds. The more you know about a business, the less likely you are going to make mistakes. Unfortunately, you will not be able to understand every business and you need to stick to your circle of competence. As such, there is a strict rule that value investors follow —“If it is not in your circle of competence, move on.”

Price vs Value

“Price is what you pay, value is what you get.”
– Warren Buffett

A value investor must recognise the difference between price and value. Price is the number that the market (Mr. Market) tells us the business is worth, but its value (commonly known as intrinsic value) is the real worth of the business. Let’s say you bought a farm for $10,000 from Mr. Market. The next day, Mr. Market tells you that the farm is now worth $11,000. Are you going to sell it to him? Probably not. Even if you are going to make a small profit, you have bought a farm and you want to make the best use of it by cultivating the land. The following day, Mr. Market tells you it is worth only $9,000. Are you going to sell because you are making a loss on paper? I don’t think so. The fundamentals of the farm did not change.

The value investor takes the same approach when investing in businesses. A stock is a piece of a business; it is not just a number on a screen that moves up and down every second. When you own a business, just like when you own a farm, you are not going to sell it just because the price changed. This is what value investing is about, focusing on the intrinsic value of businesses. For the value investor, the day-to-day movements in stock prices are just noises and should be ignored.

There is no exact formula to calculate the intrinsic value of a business, but it all comes down to estimating how much cash flow the business will produce in its lifetime. If you are  investing in a business, what is your aim? To make more cash in the future. It is obvious that the business, too, should be making more cash. This is the concept of cash flow, the total amount of cash produced by the business from its operations minus the total amount of cash used by the business.

Since money today has more value than money in the future, future cash flows have to be discounted at a proper discount rate. The intrinsic value of the business will be all those discounted cash flows of the business produced in its lifetime.

Estimating these future cash flows and choosing an appropriate discount rate requires doing a deep analysis of the business, for example, by looking at the balance sheet and income statement. It is also important to look at the competitors, to understand the superiority that this business has over them. Moreover, knowing the management is essential, since when you are investing in a company, you are basically hiring the CEO and all the other managers. Wouldn’t you want to hire the best people?

Margin of Safety

“If you were to distill the secret of sound investment into three words, we venture the

motto, MARGIN OF SAFETY” 

– Benjamin Graham 

Benjamin Graham’s concept of a “margin of safety” is extremely important. Investors are all humans and humans make mistakes, no matter what your IQ. As such, to prevent us from losing money in the stock market, we should demand a margin of safety when buying a company.

If, let’s say, after a thorough investigation of a business, the value investor estimates the intrinsic value to be $100/share. The stock is currently trading at $90/share. That doesn’t mean you should buy. It will be more appropriate to take a margin of safety of, let’s say, 25%. You will only buy the stock at $75/share. Once again, there is no formula to calculate the margin of safety and it depends on the stock, industry and sector.

Do You Still Think Value Investing Is Boring?

Value investing is often considered boring investing since it does not involve looking at stock prices and trading every day, however, it is far from boring. Most of the important work of the value investor takes place behind the scenes. At the same time, value investing has proven itself to be one of the most effective ways of beating the market over the long term. The real question is, whether you want to look “not boring” and speculate on making shortterm gains with a certain outcome to make a long-term loss or you want to increase your chances of beating the market over the long term?

Thanks to eToro’s consultant Mati Alon (@Benoak) for helping me with the article.

Mohammad Ishfaaq Peerally is a Popular Investor on eToro. Residing in Mauritius, he has a degree in Theoretical Physics, but has shifted his focus to become a full-time investor on eToro.

This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without taking any particular recipient’s investment objectives or financial situation into account, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be, taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilising publicly available information.