What Is Value Investing
“The secret to investing is to figure out the value of something – and then pay a lot less.”
Joel Greenblatt
What is value investing?
We have discussed in my last post below that the odds are piling up against retail investors wanting to pick stocks to earn some extra-ordinary return.
So still want to pick stocks? Let us examine how many people do stock picking.
These are just a few comments in VSolar thread in i3investor today on 29th April 2015. Let see how do these people pick stocks.
“My friend just call me say he gain around 3million+ so far
in this counter”
in this counter”
“buy buy....”
“VSOLAR closed yesterday at 1-month low after breaking 46sen last Wednesday.
It may stay around 20sen in short term view.”
It may stay around 20sen in short term view.”
“TA also weekly chart also shooting star and bearish engulfing,,that mean next month will extended drop...”
“Lamlam33, the q buy abt 60,000 at 0.23 are fake ones. The clue is at the sellers at 0.235. If the selling pressure keep increasing. Meaning that the operators are desperately want to sell the shares at 0.235.”
“i sell 1 vsolar at 0.44 plus little money can buy 3 mqtech.. now uptrend buy 0.145 mqtech go to 0.25 that mean (10.5x3 = that means can earn 31.5 sen)”
“6 days drop 51%. Now sellers q are building up at 0.23. 60,000 q buy at 0.23 just now was all matched”
“They didn't want to push up to 0.24 just now. Meaning they don't want people to escape.”
“this vsolar came from 11cts and is still a loss making company and the warrants went down to 3.5cts”
“This morning bought T 0.255 cut loss at 0.225 ==;”
“early morning 30 min only loss Rm3k @%$”
“Now rebound :'( I sell all , loss 17k...... “r
“Bought 0.40, sell 0.23 :"( “
“I bought 36 sell 25”
“I bought 0.32 haven;t yet sell..now loss 49k”
“i bought at 0.34..also havent sell yet..i think they will play 1 more round before right issue ex date.. “
“Today's candlestick is a bottom reversal signal with volume, tomorrow should be good, maybe testing 0.30 again. “
“Tomorrow strong rebound.”
What can we deduce from above?
- People like to play hot stocks in the market. 64.25m shares of Vsolar, equivalent to 22% of its total shares outstanding of 282m were changing hands today.
- People like to invest in loss making company.
- People like to play cheap penny stock, it is just 25.5 sen for Vsolar, and Mqtech 14.5 sen and know Mqtech will go to 25 sen.
- Some people can make millions in speculating cheap stocks. RM3m to be precise.
- Not a single one talked about value, just price, price and price.
- People like excitement in the stock market, plenty of actions, up and down. Six days can drop 51%! Can make RM3m!
- People use obscure terms describing things, something hard to understand and comprehend, and all about price; shooting star, bearish engulfing.
- People can predict about share prices.
- Buy high sell low seems to be a common investing strategy.
- They talked about playing horizon in terms of days, and hours.
- Playing is hope, hoping others to “push” up the share price to benefit them.
- Losing 49k, or even hundreds of thousands in Vsolar seems not a problem for people, but paying a few hundred to learn something, or to engage an advisor is a big problem.
- Tomorrow is always a better day for this stock.
What else can we deduce from the conversations if not some or all of the above? They buy 25 sen stock of Vsolar because it is value investing, investing in a low priced stock? They buy Vsolar cheap because it is deeply undervalued and one of this days, its price will rise to its intrinsic value of say $1? Give me a break.
All value investors will avoid the predicament of investing in crappy stock like Vsolar. With that not losing any money, half the battle in investing is won.
What is value investing?
Many people think value investing is buying cheap stocks – those that are trading at low price to earnings or low price to book value. I am not surprised that some people even think that value investing is buying low-priced stocks, those penny stocks selling for a few cents.
But this is far from truth in the perspective of a true value investor.
Charlie Munger, who has influenced Buffet in purchase of Coca Cola and other seemingly high price acquisitions mentioned it out clearly.
“All intelligent investing is value investing - acquiring more than you are paying for. You must value the business in order to value the stock.”
Munger explained further,
“You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”
So, value investing is intelligent investing. Value investing is about looking for a mispriced gamble, getting more than you are paying for. It is not just about buying cheap stocks. You must know about the business and hence the value the business. It is still a gamble, not a riskless endeavour, but by knowing the business and its value, and a little diversifications, the probability of winning is higher.
What did Buffett say about value investing?
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote…
“We think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labelled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”
Origin of Value Investing
Value investing was first made known by Benjamin Graham as a set of tenets when he wrote Security Analysis in 1934. Fundamentally, value investing involves buying stocks that are out-of-favour in the market due to investor irrationality. This irrationality, in the extreme, can often push a stock’s price well below its true value. A shrewd value investor seeks to determine the true value of such stocks, thus taking advantage of this type of investor irrationality.
There are several key principles and concepts that underpin the value investing mind-set and are central to the philosophy espoused by Graham. Two principles in particular stand out: firstly, the value investor always takes take a business owner’s perspective when analysing a company. Secondly, the value investor always counts on the irrationality of the markets in the short term (Mr. Market). Once these two principles are established during the evaluation of a stock for purchase, the value investor must follow the additional principles of determining intrinsic value and a margin of safety.
In short, the key principles are:
1. Price is not value
2. Mr. Market is a crazy guy
3. Every stock has an intrinsic value
4. Only buy with a margin of safety
5. Diversification is the only free lunch
Key Principle 1: Price is not value
The first key lesson is that the worth of a business is independent of the market price. A stock quote from day to day is only how much just the few shareholders who bother to trade that day decide their investment is worth. It is categorically not the worth of the entire company.
This is the reason share prices so often spike when being bid for by an acquirer, who generally has to pay something closer to fair value. Investors should understand that the share price is like the tip of an iceberg – you can see it, but you’ve no idea how big or small the iceberg is below the surface unless you put on your dive suit.
As Ben Graham observed: “price is what you pay, value is what you get”, meaning that big swings in the market don’t necessarily mean big swings in value. When you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity? As long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.
Key Principle 2: Mr. Market is a crazy guy
In Graham’s “The Intelligent Investor”, a book which is required reading for all new analysts at top investment firms, the author conjured his now infamous parable of Mr. Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr. Market. He’s a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis. But Mr. Market is something of a manic depressive whose quotes often bear no relation to the state of the underlying business – swinging from the wild enthusiasm of offering high prices to the pitiful gloom of valuing the company for a dime. As he explains, sometimes you may be happy sell out to him when he quotes you a crazily high price or happy to buy from him when his price is foolishly low. But the rest of the time, you will be wiser to form your own ideas about the value of your holdings, based on updates from the company about its operations and financial position.
Key Principle 3: Every stock has an intrinsic value
The critical knowledge an investor needs to take advantage of Mr. Market’s behavior and inefficient prices is an understanding of the true value of a business. The true value of a business is known as its ‘intrinsic’ value and is difficult, though not impossible, to ascertain.
Most investors preoccupy themselves with measures of ‘relative’ value which compare a valuation ratio for the company (perhaps the price-to- earnings, price-to-book or price-to-sales ratio) with its industry peer group or the market as a whole. Inevitably though, something that appears to be relatively cheap on that basis can still be overvalued in an absolute sense, and that’s bad news for the Value Investor who prefers to tie his sense of value to a mast in stormy waters.
Intrinsic valuation looks to measure a company on its economics, assets and earnings independently of other factors. But be warned, establishing an intrinsic valuation is not straightforward and there are multiple, contradictory ways of calculating it. We will explain the ins and outs of valuation techniques later for those that wish to delve further into the dark arts of valuation.
Key Principle 4: Only buy with a margin of safety
When Warren Buffett describes a phrase as the “three most important words in investing” every investor owes it to himself to understand what it is. The words “Margin of Safety” come from the writing and teachings of Graham and have ensured that his followers have prospered in many market environments. But what does it mean and why is having a large margin of safety so important?
Seth Klarman, one of the modern era’s greatest Value Investors, defines a margin of safety as being “achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility.”
In other words, once you are certain that you have a fair estimate of a share’s intrinsic value you must only buy the share when you are offered a price at such a discount to that value that you are safe from all unknowns. The difference between the market price and the intrinsic value is the margin of safety. As Buffett once opined:
“You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”
Valuation is an imprecise art and the future is inherently unpredictable. Having a large margin of safety provides protection against bad luck, bad timing, or error in judgment. Given that the investor is using his own judgment, the technique introduces a cushion against capital loss caused by miscalculations or unpredictable market movements (i.e. the value of the stock falls further).
Opinions are divided on how large the discount needs to be to qualify the stock as a potential ‘buy’. Indeed, the bad news is that no-one really agrees on this – for two reasons. First, as we have already discussed, determining a company’s intrinsic value is highly subjective. Second, investors are prepared to be exposed to different levels of risk on a stock by stock basis, depending on how familiar they are with the company, its story and its management.
In his writings, Graham noted that: “the margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price”. He suggested looking for a margin of safety in some circumstances of up to 50% but more typically he would look for 33%.
Key Principle 5: Diversification is the only free lunch
Diversification is incredibly simple to understand and plainly common sense – you shouldn’t put all your eggs in one basket – but in practice (like everything that is supposed to be simple) it seems to be extremely difficult to pull off. The majority of individual investors are massively under-diversified, often with an average portfolio size of only four stocks.
The value investing camp splits into two on this topic. Fundamental value hunters who follow Warren Buffett tend to fall into the ‘focus portfolio’ camp believing that you should put all your eggs in just a few baskets and watch them like a hawk. While it may be true that 71% of the benefits of diversification do come from the first five stocks in a portfolio, this kind of attitude requires a great gift for security analysis and is particularly risky given the high exposure to stock specific disasters – the kinds that value stocks are prone to.
An alternative approach is that espoused by the more ‘quantitative’ value farmers who seek to ‘harvest’ the value premium from the market. As we shall see a little later, in his deep value strategies Graham recommended owning a portfolio of 30 bargain stocks to minimize the impact of single stocks falling into bankruptcy or distress, while Joel Greenblatt recommends a similar level of diversification when following his Magic Formula strategy.
Making sense of value investing principles
Making money using a value investing strategy requires the mastery of just a few principles as discussed. What should be clear now is that while intrinsic value and margin of safety make perfect sense in the context of value stock selection, defining precisely how to execute each principle requires some careful thinking and the acceptance that some nuances can only be decided by the interpretation and preference of each investor.
But does value investing actually work in real life investing? What are the evidence? We will talk about it the next time.
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