"If you want higher returns, you also have to take a higher risks."
It's a popular adage in the investment world by seasoned professionals as well as amateur investors who have little experience in the market. This opinion is exaggerated by those who demonize any investment in the capital market and have the belief that investing in stocks is simply a losing game.
Undoubtedly, the question of risk is a legitimate one that must be considered. People tend to perceive small losses more than large profits.
For value investors, risk is an even more significant issue because they are less likely to overestimate themselves and are well aware of their investing imperfections.
As the father of value investing Benjamin Graham aptly said:
"The investor’s chief problem, and even his worst enemy, is likely to be himself!"
The value investor is keenly aware of this and always tries to make the risk of his investment as low as possible. He depends on a number of tools that help him reduce risk and increase long-term returns.
How does he do it?
Well, first of all, investing is not a game for the value investor. Value investors don’t invest their money in stocks but in companies.The value investor wants to invest in a company that generates value through products and services, which adds value to the company and the share price.
Value investors focus their investments on things they understand and whose success they can more easily assess. Value investors concentrate on their circle of competence, where they have a greater chance of making the right decisions.
Value investors don’t follow every trend and every opinion. Rather, they focus on acquiring companies that have an outstanding position in the market. These investors call it the "moat." They prefer companies that have demonstrated their success in the market over the past years and have a strong track record. The probability that these companies will continue to perform is higher than companies that do not meet this criteria.
The most important thing of value investing is minimizing risk and the margin of safety. This is the central element for every value investor because the margin of safety not only reduces the risk, it also increases the return. This is how guru investors like Warren Buffett (Trades, Portfolio) achieve an average return of 20% over decades.
How is this possible?
Well, if the value investor has found a company that meets his criteria for an outstanding one, he does not run straight to Mr. Market and buys its stocks. No!
First of all, the value investor is looking for the intrinsic value of the company. This is the basis for his considerations regarding a purchase. As a frugal person, whose first rule is not to lose money, the value investor is not willing to spend too much on the business. His goal is to buy the company at a discount compared to its intrinsic value. This way, he will get more value than what he paid. In other words, he may "pay" 50 cents for a dollar.
That's good for him in two ways. Since the market tends to equalize the price of a stock to the value of a company in the long run, the value investor can assume that the price of the company, i.e. the stock, will also rise in the long run. But as the market also tends to exaggerate, it is more than possible that the price of the stock will exceed the value of the company. And, sooner or later, Mr. Market will gain a better understanding about the quality of the company. The cheaper the value investor bought the stock, the higher his return will be.
Many people do just the opposite. They buy at a high level, where returns are small, because an overpriced investment would have to be even more expensive to generate returns. Obviously, it is more difficult for a more expensive stock to continue to gain value. At the same time, the risk of loss increases enormously. At some point, no one is willing to buy the stock because it is too pricey.
Investors often lose when they buy high
For the value investor, the risk of losing money is low. Since he has bought the company below value, the likelihood that the price of the stock continues to decline is low. That's why he doesn’t mind if the stock should fall in the short-term. He uses these set backs as a buying opportunity to acquire even more shares of the outstanding company. The value investor knows that in the long run, the price of the company will rise again and provide above-average returns for the value investor.
Of course, the value investor may be unlucky if the company turns out to be less outstanding than he presumed. In this case, he also loses. But his loss is much lower because of his low purchase price compared to those investors who bought at much higher prices. And if the company has to be liquidated, he may make a good profit if the book value is higher than the purchase price.
Value Investor Monish Pabrai has pointed out perfectly in his book „The Dhandho Investor“ when he writes: „Heads I win, tails I don’t lose much!“
