The world of investing can be a complicated place to navigate. Where do you start? For beginners, the sheer volume of information available to them on the internet has only served to make the process more complex and increase confusion.
Moreover, it appears that most investment strategies are now called value strategies, even though they have little in common with the traditional value strategies laid out by the likes of Benjamin Graham and Walter Schloss.
This begs the question: What are the fundamental principles of value investing and how should you interpret them?
Joseph Calandro Jr., Fellow of the Gabelli Center for Global Security Analysis at Fordham University and author of "Applied Value Investing" published a paper last year which seeks to answer this question.
The paper concludes that there are six key principles to value investing and by following these simple rules, you are likely to profit from this strategy without any major hiccups.
Principle One: Approach the market as a contrarian -- if you think like everyone else, you are going to value things like everyone else.
The first principle is based on contrarianism, the idea that to be a value investor you have to act with a contrarian attitude -- it is an essential part of the school of thought. However, it is often the case that investors fail to follow this first point for fear of being wrong and investing against the market. Calandro quotes a paragraph from Liar’s Poker:
“Everyone wants to be [a contrarian], but no one is, for the sad reason that most investors are scared of looking foolish.”
Principle Two: Understand the risks and opportunities associated with value subjectivity.
Principle two is based on the idea that every single value investor has a different idea of what may or may not constitute value. Seth Klarman (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) are two of the most revered value investors of our time, but both have different ideas of what constitutes value, which you can see from their differing portfolios.
Principle Three: Approach valuation rigorously from the bottom up.
Principles two and three work together. The value investor needs to understand the risks and opportunities associated with value subjectivity and by approaching valuation rigorously from the bottom up, they can compute their independent estimate of intrinsic value, without having to depend on the judgment of others.
Most of the time, even professional investors do not bother to read the financial documents associated with their investments. In most cases, just reading SEC filings can give investors a huge edge over the rest of the market.
Principle Four: Formulate conservative valuation assumptions.
It is impossible to tell the future and therefore it is impossible to accurately predict what a company will be worth in three or four years time. Therefore, it is key to formulate conservative valuation assumptions in case things do not go according to plan:
“Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuation derived therefrom.” – Seth Klarman (Trades, Portfolio)
Principle Five: Understand how to put mean reversion to work for an investment instead of having it work against one.
Most of the time an investment's value will revert to the mean, understanding mean reversion and its benefits/drawbacks is another key tool in the value investors tool kit.
“...during the depths of the financial crisis when many people were panicking, Mr. Buffett insightfully diagnosed the likelihood of mean reversion that led to a number of high profile and ultimately successful investments” -- Calandro, Joseph, Value Investing General Principles
Principle Six: Invest with a margin of safety.
Finally, principle number six is to invest with a margin of safety. However, I should say that all these principles are cumulative and only when you have understood principles one through five, and have followed them when hunting for investments, principle six comes into play.
Waiting for the opportune moment to buy is probably the most important part of value investing, although without doing your research first, how will you know when it is the right time to enter a position?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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