It’s essential to consider which investment strategy will work best for you. It must work well but also should be compatible with you as an investor. In this series, we’ll explore Value Investing as one possibility starting with an introduction to value investing.
A Compatible Strategy Can Make us Better Investors
That is because a strategy serves as a decision-making framework that helps provide clear and long-term thinking. And, the strategy needs to be aligned with the investors risk tolerance, goals, skill set, and temperament for investors to stay with it long-term.
According to Dalbar, the average investor’s annualized returns were 4.0% over the past 30 years. That return compares poorly to the stock market average return of 10.2% for the same period.
It is primarily investor’s emotions and behavior that contribute to this performance gap, as discussed here.
“Performance chasing” is one to the contributors. That is where investors move from company to company or strategy to strategy based on what is working best at the moment.
Performance chasing often occurs just as the company or strategy peaks and falls out of favor. Moreover, it can lead to underperformance, even in good markets.
A strategy that is compatible with our temperament helps anchor us in a comfort zone. Our comfort zone, in turn, helps boost confidence while providing the framework in which to make sound investment decisions.
A strategy serves to minimizes emotions and behavioral mistakes both that tend to occur during turbulent market times when we most need an anchor.
We started this series with Dividend Growth Investing (DGI). So now, we’ll go through Value Investing and as we do think about which strategy is the right fit for you.
Value investing is buying stocks on sale, when they are priced below the underlying value of the company, and selling the stock when the company reaches full value.
Benjamin Graham is the father of value investing. His idea behind value investing is to find investments that are “on sale.” That is stocks priced in the market below the actual or “intrinsic value” of the company.
Value is different from price. The distinction is: the price is what you pay, and value is what you get. Companies bought on sale below their intrinsic value provide a buffer or “margin of safety” against potential loss.
Value investors buy the shares on sale, and then as owners of the more valuable underlying company, they wait patiently. That is until the share price catches back up to the underlying intrinsic value.
“The intelligent investor is a realist who sells to optimists and buys from pessimists.”
― Benjamin Graham, The Intelligent Investor
The Efficient Market Theory
The Efficient Market Theory (EMT) popularized in the 1970s proposes that information about a company or an investment is immediately available to all investors and reflected in the stock’s price.
It follows then that the investor cannot “beat the market” because the stock price changes immediately to reflect any good or bad news that everybody already knows. They argue that you cannot buy or sell stock at an advantage because the market is so efficient.
Value investors turn the EMT on its head. They believe the share price often has nothing to do with the underlying value of the company the shares represent.
The Problem with the Efficient Market Theory
The problem is the EMT discounts human nature, including the emotions, fear, and greed. These are timeless human characteristics. Moreover, people have different perceptions, different views of the future, and different abilities to analyze situations.
Still, the EMT assumes everyone gets the information promptly and knows exactly what to do with it. Also, they are capable of acting on it immediately and in a rational manner.
Does that sound like the real world to you? It’s not the world where I live.
Emotions and behavior are significant factors that Dalbar finds contributing to the underperformance of individual investors over the decades.
The Investors Dilemma
The markets are efficient at times. So, the EMT is credible to a point. However, even then, there are always pockets of inefficiencies that present opportunities for value investing.
How else could the EMT explain the consistent and long-term success of investors like Warren Buffett and others?
They know, as we do that to make money in the market, we need to “buy low and sell high.” That’s easier said than done if the market is efficient. That puts us in the position of trying to understand the direction of the market.
Anticipating the market’s direction is a challenge in itself. However, even if you could get that right, how can you possibly know the highs or lows to buy at the bottom or sell at the top?
That is impossible. So, the investors’ dilemma is trying to know something we can’t. We really can’t see the market’s future.
Does that mean investment decisions, centered around our hard-earned money, must be rooted in guesswork? Not at all.
The solution is to focus on what we know or can reasonably estimate. The two variables in value investing that we can know, or reasonably estimate, are “intrinsic value” and “margin of safety.”
When we change to this mindset and apply these two variables of value investing the answers become more apparent.
An investment is simply a commitment of money with the expectation of receiving even more money or cash flow in the future.
The intrinsic value or underlying value of the investment is the total money that can be taken out of an investment or business during its remaining life.
Since this often occurs over many years this future money is usually discounted over the investment lifetime back to the present.
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.” – Warren Buffett
Intrinsic value is an estimate and not a precise value. Since this is an introduction to value investing we’ll cover estimating intrinsic value in the upcoming article on valuation. But, for now, let’s focus on its application.
Application of Intrinsic Value
When we buy a stock, it represents the ownership interest in an actual business with an intrinsic value. The intrinsic value is independent of the share price on any given day.
An estimate of the intrinsic value enables us to invest in a disciplined manner. Without the intrinsic value, we are speculating or gambling; not investing.
That is because the price is what we pay, and value is what we get; intrinsic value shows us the difference.
Value investors buy a company when the valuation is compelling and the business’ prospects most misunderstood. And, the stock price is depressed below the intrinsic value. The business is on sale.
Over time, the stock price rises when others begin to understand this gap exists, and the stock prices increase to reflect the intrinsic value of the business.
Most Investors Ignore Intrinsic Value
The vast majority of investors feel they own a piece of paper, the stock certificate, with a price the market changes continuously. They become obsessed with stock price quotes and financial news.
The more we focus on price quotes, and not the intrinsic value, the more likely we’ll make an irrational or emotional mistake. We become another Dalbar statistic because we are speculating, not investing.
One of Benjamin Graham’s many insights is investors who try to follow the market are transforming their basic advantage into a disadvantage.
“…Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. By refusing to let Mr. Market be your master, you transform him into your servant.”
– Benjamin Graham, The Intelligent Investor
Other Measures of Value
We’ll highlight a few other characteristics in this introduction to value investing, including:
- a low price to book value (P/B);
- low price to earnings ratio (P/E);
- a low price to cash flow ratio (P/CF);
- low price to sales ratio (P/S) relative to the industry;
- above industry or company’s historical dividend yield; and,
- low share price.
Studies cited in the next article show a historical correlation between these investment characteristics and above-average investment rates of return over a long investment horizon.
Margin of Safety
The margin of safety is the difference between the intrinsic value of the investment and the price you pay. The goal of the value investor is paying less than the intrinsic value and buy the company on sale.
The margin of safety is needed to cover the potential errors we make in estimating the intrinsic value or unforeseen changes in the business.
This discount is critical because it provides a margin for error to help us avoid permanent loss.
So, the margin of safety is about risk management. The larger the margin of safety required by the investor, the more margin for error provided.
“…to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion.”
-Benjamin Graham, The Intelligent Investor
Application of Margin of Safety
Let’s assume you estimate the intrinsic value of a business is $40/share, and you require a 30% margin of safety. Your target purchase price is $28/share ($40 X 70% = $28/share).
If, in time, the stock reaches your estimate of intrinsic value, you realize a 42% return on the investment.
However, if, for some reason, you overestimated the intrinsic value. Alternatively, an unforeseen event occurs, and the price only rises to $32/share you still have a gain of 14% gain.
Eliminating the Investor’s Dilemma
Value investing is about purchasing a company’s stock at a price below the intrinsic value of the company. The investments then sold as the market price approaches intrinsic value.
The proceeds from the investments get recycled into other investments offering a more significant discount to intrinsic value.
The value investor has the luxury of ignoring the market. Value investing runs counter to market psychology and sentiment.
The buy and sell decisions get reduced to a discipline by adhering to the principles of intrinsic value and margin of safety.
“The true investor scarcely ever is forced to sell his shares, and at all other times, he is free to disregard the current price quotation. He needs pay attention to it and act upon it only to the extent that it suits his book, and no more.”
– Benjamin Graham, The Intelligent Investor
What we Learned
- A compatible strategy makes us better investors by providing a framework for clear long term thinking consistent with our circumstances and temperament.
- Value investing is buying stocks on sale, priced below the intrinsic value of the company, and selling when they reach that value.
- The investor’s dilemma disappears by focusing on value and ignoring the market.
- Investing is more disciplined with intrinsic value and margin of safety.
In our next article on value investing we’ll answer the question, Does Value Investing Work?