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Benjamin Graham - Three Most Important Pillars of Value Investment

January 27, 2012 | About:
Value investors follow different methods of picking their own stocks, but they are still based on three pillars of value investment philosophy which had been laid out by Benjamin Graham and followed closely by a lot of our gurus, including legendary Warren Buffett. Any investors, who want to do value investment, should etch into their hearts and minds these three pillars, in order to not make any terrible mistakes in their investing careers.

First is the circle of competence, which investors find themselves comfortable to stay in. Investors might have deep knowledge of certain industries such as biotech, technology, retail, manufacturing, etc., through knowledge accumulation over time. Investors may broaden their circle of competence during their investing lives by being learning machines. Nevertheless, the most important thing is to stay in their circle of competence when it comes to choosing opportunities for their own investments. Charlie Munger once said that the simple way to get success in life is to play on the field that we are the best at, otherwise we would get beaten up pretty fast.

Warren Buffett has been following this quite strictly: “One of the things we try very hard to do at Berkshire, is to stay within what I call our circle of competence.” That is why Warren Buffett never bought a single share in a technology company such as Microsoft (MSFT) — even while being very close friends with Bill Gates — or biotech companies. Nevertheless, he has broadened his circle of competence over time, and with the support of Charlie Munger and his associates, Berkshire Hathaway has moved into technology field by acquiring BYD (HKG:1211) and Intel (INTC). So he still keeps himself a learning machine.

The second pillar in value investment is Mr. Market. This pillar depicts well the wide mood swing of Mr. Market. Now just imagine that you own a business that you know is exactly worth $1,000. Then, if your business is trading in the stock market, its value would change every single second, every single day. Sometimes when Mr. Market is happy, he is willing to value your business at $10,000, but when he is sad or depressed, he might just value your business at $10.

So at $10,000, do you want to sell your $1,000 business? And at $10, do you want to sell your $1,000 business? It is ALL your decision. As Benjamin Graham explained it: “If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position." So the market is there to serve you, not to instruct you. We shouldn’t let the Mr. Market lead us; instead we should take advantage of the time when he is sad and depressed.

Last but not least, the third pillar of value investment is the concept of Margin of Safety, meaning that investors should buy companies for much less than their true worth, at around 30% or more. For example, if the business is calculated to be worth $1,000, investors should only buy in when the market values that business for at most $700, or much less. That is like buying a dollar bill for only 70 cents or less. Investors should require a margin of safety because, first, the intrinsic value of the business or an asset is in the range, not the absolute number. With the same set of facts and figures, two well-informed investors might come to two figures of 10% difference on the intrinsic value. And second, because we can’t foresee and hedge any single risks in certain type of investments.

According to Buffett, it is like driving a truck: "If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety. You must leave yourself an enormous margin of safety. You build a bridge that 30,000-pound trucks can go across and then you drive 10,000-pound trucks across it. That is the way I like to go across bridges."

And that can be easily applied to investing discipline for him: “Never depend on a good sale. Get a purchase price so attractive that even a mediocre sale will produce good results.”

In conclusion, value investors can follow many methods to pick up stocks for their investment portfolio, it can be cigar butts positions, it can be liquidation plays, it can be arbitrage plays, it can be buying a great companies to hold for the long term, but overall, the three pillars above are the best guidance ever for investors to be successful in their investment professions.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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