We've discussed elsewhere the paradox that while value investing is the tried and trusted method of some of the world’s most famous, wealthy and influential stock buyers, for some reason it is still widely overlooked by the majority of institutional investors. We argue that this short- sightedness of the professionals works to the advantage of the motivated and determined individual investor. But where to begin? Value Investors worldwide disagree on many aspects of investing, but rarely on some fundamental principles!
Key Principle 1: Price is not value
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 has 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?
Key Principle 2: Mr Market is a crazy guy
Key Principle 3: Every stock has an intrinsic value
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 over valued 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.
Key Principle 4: Only buy with a margin of safety
Key Principle 5: Diversification is the only free lunch
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. 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, Graham recommended owning a portfolio of 30 bargain stocks to minimise 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
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