Value investing is an investment paradigm that was birthed by the thoughts and ideas set forth by Benjamin Graham and David Dodd in Security Analysis. It has recently been associated with Ben’s star pupil, Warren Buffet and his methods, however there are many forms of value investing and it shouldn’t be held in a stereotype. For example Warren classifies his purchases as “finding outstanding businesses for reasonable prices“ while Benjamin looked for statistical bargains. Today’s Warren Buffet wouldn’t buy RadioShack, but Benjamin Graham would consider it. My point in bringing up the differences between these two is simple – Value investing isn’t a fixed methodology that you follow from point A to point B, it is a philosophy that is based on two easy-to-understand, yet complex master principles.
Value Investing defined
It is my belief that all value investors act within a realm that is governed by the principles of margin of safety and an understanding of market fluctuations (the Mr. Market analogy)
Margin of Safety: I covered margin of safety in more depth here: “Margin of Safety: Your Safety Net.” to go over it briefly. Margin of safety is the principle of developing a safety net into all your investments – this safety net can be the difference between tangible book value and the current share price, or it can be something like the value of a patent that is being undervalued on the books. When it comes down to it, margin of safety is the difference between the price you are paying and the value you are calculating as the real value of a firm.
Mr. Market Analogy: the analogy goes like this, you are in business with a guy named Mr. Market (ironic isn’t it) his mood changes constantly, you can say he is bi-polar. Some days he thinks you are going to undercut him so he offers to buy you out at ridiculously high valuations, other days he is depressed and what’s to get out of the business so he tries to sell you his stack in the business at dirt cheap prices. Mr. Market like the stock market is irrational. It is run by the emotions of greed and fear. (With a little of blind hope thrown in) in the short term the market fluctuates causing share prices to go up and down. On the other hand in the long term the market will more than likely appreciate the true value of a business.
Benjamin Graham searched statistical bargains, Warren Buffet looks for great businesses at fair prices, Peter Lynch found companies that had high growth rates and Walter Schloss simply put, bought cheap stocks. What do these guys all have in common? They all consistently beat the market and they all were value investors. They were value investors not because they all invested with the same methods though they shared some common ground, but because they applied the governing principles of margin of safety, and Mr. Market (an understanding of market fluctuations).
Value investing is dynamic and every changing. It can be as academic as calculus or as common sense-based as looking for companies that you understand.
Until next time,
"Value investing is simply figuring out what something is worth and paying alot less for it "– Joel Greenblatt