| Different sources define value investing differently. | | | | its calculated value. Surprisingly, this fact alone |
| Some say value investing is the investment | | | | separates value investing from most other |
| philosophy that favors the purchase of stocks | | | | investment philosophies. |
| that are currently selling at low price-to-book | | | | True (long-term) growth investors such as Phil |
| ratios and have high dividend yields. Others say | | | | Fisher focus solely on the value of the business. |
| value investing is all about buying stocks with low | | | | They do not concern themselves with the price |
| P/E ratios. You will even sometimes hear that | | | | paid, because they only wish to buy shares in |
| value investing has more to do with the balance | | | | businesses that are truly extraordinary. They |
| sheet than the income statement. | | | | believe that the phenomenal growth such |
| In his 1992 letter to Berkshire Hathaway | | | | businesses will experience over a great many |
| shareholders, Warren Buffet wrote: | | | | years will allow them to benefit from the wonders |
| "We think the very term 'value investing' is | | | | of compounding. If the business' value compounds |
| redundant. What is 'investing' if it is not the act of | | | | fast enough, and the stock is held long enough, |
| seeking value at least sufficient to justify the | | | | even a seemingly lofty price will eventually be |
| amount paid? Consciously paying more for a | | | | justified. |
| stock than its calculated value - in the hope that it | | | | Some so-called value investors do consider |
| can soon be sold for a still-higher price - should be | | | | relative prices. They make decisions based on |
| labeled speculation (which is neither illegal, immoral | | | | how the market is valuing other public companies |
| nor - in our view - financially fattening)." | | | | in the same industry and how the market is |
| "Whether appropriate or not, the term 'value | | | | valuing each dollar of earnings present in all |
| investing' is widely used. Typically, it connotes the | | | | businesses. In other words, they may choose to |
| purchase of stocks having attributes such as a | | | | purchase a stock simply because it appears cheap |
| low ratio of price to book value, a low | | | | relative to its peers, or because it is trading at a |
| price-earnings ratio, or a high dividend yield. | | | | lower P/E ratio than the general market, even |
| Unfortunately, such characteristics, even if they | | | | though the P/E ratio may not appear particularly |
| appear in combination, are far from determinative | | | | low in absolute or historical terms. Should such an |
| as to whether an investor is indeed buying | | | | approach be called value investing? I don't think so. |
| something for what it is worth and is therefore | | | | It may be a perfectly valid investment philosophy, |
| truly operating on the principle of obtaining value in | | | | but it is a different investment philosophy. |
| his investments. Correspondingly, opposite | | | | Value investing requires the calculation of an |
| characteristics - a high ratio of price to book | | | | intrinsic value that is independent of the market |
| value, a high price-earnings ratio, and a low | | | | price. Techniques that are supported solely (or |
| dividend yield - are in no way inconsistent with a | | | | primarily) on an empirical basis are not part of |
| 'value' purchase." Buffett's definition of "investing" | | | | value investing. The tenets set out by Graham |
| is the best definition of value investing there is. | | | | and expanded by others (such as Warren |
| Value investing is purchasing a stock for less than | | | | Buffett) form the foundation of a logical edifice. |
| its calculated value. | | | | Although there may be empirical support for |
| Tenets of Value Investing | | | | techniques within value investing, Graham founded |
| 1) Each share of stock is an ownership interest in | | | | a school of thought that is highly logical. Correct |
| the underlying business. A stock is not simply a | | | | reasoning is stressed over verifiable hypotheses; |
| piece of paper that can be sold at a higher price | | | | and causal relationships are stressed over |
| on some future date. Stocks represent more | | | | correlative relationships. Value investing may be |
| than just the right to receive future cash | | | | quantitative; but, it is arithmetically quantitative. |
| distributions from the business. Economically, each | | | | There is a clear (and pervasive) distinction |
| share is an undivided interest in all corporate | | | | between quantitative fields of study that employ |
| assets (both tangible and intangible) - and ought to | | | | calculus and quantitative fields of study that |
| be valued as such. | | | | remain purely arithmetical. Value investing treats |
| 2) A stock has an intrinsic value. A stock's intrinsic | | | | security analysis as a purely arithmetical field of |
| value is derived from the economic value of the | | | | study. Graham and Buffett were both known for |
| underlying business. | | | | having stronger natural mathematical abilities than |
| 3) The stock market is inefficient. Value investors | | | | most security analysts, and yet both men stated |
| do not subscribe to the Efficient Market | | | | that the use of higher math in security analysis |
| Hypothesis. They believe shares frequently trade | | | | was a mistake. True value investing requires no |
| hands at prices above or below their intrinsic | | | | more than basic math skills. |
| values. Occasionally, the difference between the | | | | Contrarian investing is sometimes thought of as a |
| market price of a share and the intrinsic value of | | | | value investing sect. In practice, those who call |
| that share is wide enough to permit profitable | | | | themselves value investors and those who call |
| investments. Benjamin Graham, the father of | | | | themselves contrarian investors tend to buy very |
| value investing, explained the stock market's | | | | similar stocks. |
| inefficiency by employing a metaphor. His Mr. | | | | Let's consider the case of David Dreman, author |
| Market metaphor is still referenced by value | | | | of "The Contrarian Investor". David Dreman is |
| investors today: | | | | known as a contrarian investor. In his case, it is an |
| "Imagine that in some private business you own a | | | | appropriate label, because of his keen interest in |
| small share that cost you $1,000. One of your | | | | behavioral finance. However, in most cases, the |
| partners, named Mr. Market, is very obliging | | | | line separating the value investor from the |
| indeed. Every day he tells you what he thinks | | | | contrarian investor is fuzzy at best. Dreman's |
| your interest is worth and furthermore offers | | | | contrarian investing strategies are derived from |
| either to buy you out or sell you an additional | | | | three measures: price to earnings, price to cash |
| interest on that basis. Sometimes his idea of value | | | | flow, and price to book value. These same |
| appears plausible and justified by business | | | | measures are closely associated with value |
| developments and prospects as you know them. | | | | investing and especially so-called Graham and |
| Often, on the other hand, Mr. Market lets his | | | | Dodd investing (a form of value investing named |
| enthusiasm or his fears run away with him, and | | | | for Benjamin Graham and David Dodd, the |
| the value he proposes seems to you a little short | | | | co-authors of "Security Analysis"). |
| of silly." | | | | Conclusions |
| 4) Investing is most intelligent when it is most | | | | Ultimately, value investing can only be defined as |
| businesslike. This is a quote from Benjamin | | | | paying less for a stock than its calculated value, |
| Graham's "The Intelligent Investor". Warren | | | | where the method used to calculate the value of |
| Buffett believes it is the single most important | | | | the stock is truly independent of the stock |
| investing lesson he was ever taught. Investors | | | | market. Where the intrinsic value is calculated |
| ought to treat investing with the seriousness and | | | | using an analysis of discounted future cash flows |
| studiousness they treat their chosen profession. | | | | or of asset values, the resulting intrinsic value |
| An investor should treat the shares he buys and | | | | estimate is independent of the stock market. But, |
| sells as a shopkeeper would treat the | | | | a strategy that is based on simply buying stocks |
| merchandise he deals in. He must not make | | | | that trade at low price-to-earnings, price-to-book, |
| commitments where his knowledge of the | | | | and price-to-cash flow multiples relative to other |
| "merchandise" is inadequate. Furthermore, he | | | | stocks is not value investing. Of course, these |
| must not engage in any investment operation | | | | very strategies have proven quite effective in the |
| unless "a reliable calculation shows that it has a fair | | | | past, and will likely continue to work well in the |
| chance to yield a reasonable profit". | | | | future. |
| 5) A true investment requires a margin of safety. | | | | The magic formula devised by Joel Greenblatt is |
| A margin of safety may be provided by a firm's | | | | an example of one such effective technique that |
| working capital position, past earnings | | | | will often result in portfolios that resemble those |
| performance, land assets, economic goodwill, or | | | | constructed by true value investors. However, |
| (most commonly) a combination of some or all of | | | | Joel Greenblatt's magic formula does not attempt |
| the above. The margin of safety is manifested in | | | | to calculate the value of the stocks purchased. |
| the difference between the quoted price and the | | | | So, while the magic formula may be effective, it |
| intrinsic value of the business. It absorbs all the | | | | isn't true value investing. Joel Greenblatt is himself |
| damage caused by the investor's inevitable | | | | a value investor, because he does calculate the |
| miscalculations. For this reason, the margin of | | | | intrinsic value of the stocks he buys. Greenblatt |
| safety must be as wide as we humans are stupid | | | | wrote "The Little Book That Beats The Market" |
| (which is to say it ought to be a veritable chasm). | | | | for an audience of investors that lacked either the |
| Buying dollar bills for ninety-five cents only works | | | | ability or the inclination to value businesses. |
| if you know what you're doing; buying dollar bills | | | | You can not be a value investor unless you are |
| for forty-five cents is likely to prove profitable | | | | willing to calculate business values. To be a value |
| even for mere mortals like us. | | | | investor, you don't have to value the business |
| What Value Investing Is Not | | | | precisely - but, you do have to value the business. |
| Value investing is purchasing a stock for less than | | | | |