What is value investing? An introduction to the philosophy’s key concepts

Abstract

  • Unlike the academic society, value investors believe that price and value are to independent elements. Price is simply the price tag that the market has put on a security. Value is the intrinsic value a security would be traded at as so forth the market was governed exclusively by rational and intelligent buyers and sellers.
  • An asset, which is offered at a price significantly below its intrinsic value, is considered a bargain. The hunt for bargains is essentially value investor’s constant quest.
  • A fundamental analysis of a security flow into a valuation. This is often determined as a span, e.g. $90-110. If the security is offered at $50 on the market, you’re offered a satisfying margin of safety. In this case, this opportunity must be considered a bargain.
  • Value investing is a risk averse strategy. “Never loose money” is the philosophy’s mantra; that’s why value investors seek safety in a stock’s balance sheet or a wide moat that ensures its long-term survival. The Dhandho-mantra “heads, I win; tails, I don’t lose much” thus sums-up the philosophy perfectly.

I’ve created dhandho.dk in an attempt to document the insights I gain during my journey into the value investing universe. This post attempts to outline the investment philosophy’s key concepts.

The distinction between price and value; say hello to Mr. Market
In 1894, the value investing philosophy’s father, Benjamin Graham, was born. Via his investment partnership Graham-Newman, Ben practiced an investment strategy that centered around the purchase of undervalued assets, mainly publicly traded stocks. He introduced the idea that price and value could deviate from one another, which is why certain assets must be considered expensive while others are cheap. Ben’s undoubtedly most recognized student, Warren Buffett, often exclaims that Graham taught him that “price is what you give, value is what you get.” An asset’s price is simply the price tag, which the market has bestowed it. Value, however, is more ‘fluffy’. In the two most renowned investment books, The Intelligent Investor and Security Analysis, Ben explains that value is the ‘price’ an asset should be traded at as so forth the market was governed exclusively by intelligent and rational buyers and sellers. ‘Luckily’, such a market does not exist. On the contrary, today’s financial markets are populated with an array of speculators and investors with different objectives, psyches and time horizons. These market participants’ behavior dictates stock market prices via their buy and sell orders. Ben’s fictitious persona, the manio-depressive Mr. Market, which is introduced in The Intelligent Investor, embeds the collective behavior of these market participants. Mr. Market can be your worst enemy if you choose to take him up on his expensive offerings. However, he can be your best friend if you accept his discount offerings. Mr. Market and the herein resident distinction between price and value is at the core of the value investing philosophy. This is the conviction that makes the existence of bargains possible.

Intrinsic value, bargains and the margin of safety
The definition of a bargain is often formulated something along the lines of “an asset, which is offered at a price significantly below its intrinsic value.” Intrinsic value – ‘the rational price’ – can be determined based on a fundamental analysis (also dubbed a valuation) of a business’ earnings power, estimated growth rates, the balance sheet etc. A valuation often flows into a span of values based on different growth and discount rates (read Why are we so clueless about the stock market?), as it’s utopia to believe one can determine an exact figure that correctly reflects a security’s so-called true value. Luckily, reaching an upshot is not the point; the intention is rather to get an idea of whether or not the opportunity may be characterized as a bargain. If one’s valuation spans between $90-110, and the security is offered at $50 by Mr. Market, it doesn’t matter which end of the valuation scale is ‘most correct’. There is in this case a sufficient margin of safety, which makes the decision a no-brainer: buy! There is an array of methods to valuing stocks and other assets, which I’ll try to treat here on the blog. For this introductory post, however, you should merely know that price and value are two components, which are not necessarily in harmony. Furthermore, when the gap between the two – your margin of safety – is sufficiently wide, you should strike.

Risk aversion and safety
You may have heard Warren Buffett say that there’s only two rules you need to obey in order to achieve investment succes: “Rule no. 1: Don’t lose money. Rule no. 2: Never forget rule no. 1.” Risk aversion is a consistent theme in the value investing litterature. For value investors, risk is not a synonym of volatility, which is the academic society’s view on the matter. Rather, value investors regard risk as the amount and likelihood of loss of capital on a given investment. Squarely put, a business with a strong balance sheet consisting of liquid assets that is offered at a price-to-book (P/BV) around/below 1, offers greater security than a ‘story stock’ in the bio-tech sector with a two-digit P/BV. Low price-to-fundamentals and the margin of safety principal acts as chaperones that ensure you do not overpay for a stock. Furthermore, one can seek safety in a business’ franchise value, which is Warren Buffett’s approach. He scouts for businesses with cemented market positions, strong brands, unique products or other characteristics that ensure a solid earning power for the years ahead (which, obviously, needs to be purchased at an attractive price.) Ben Graham’s method of choice was to seek safety in the balance sheet by not paying a price greater than the liquidation value of a business.

The fascinating Dhandho concept
In length of the previous section, safety is an embedded part of the Dhandho mantra “heads, I win; tails, I don’t lose much.” In my view, this phrase sums up the value investing philosophy perfectly, since it describes the quest of finding assets that seem to promise substantial upside potential while minimizing one’s downside risk. It’s this art I am so enchanted by that I shamelessly stole the term and added ‘.dk’. It’s a philosophy and strategy that demand a rational and contrarian mindset, a long-term time horizon, an analytical approach as well as an owner’s mentality.

All these demands to one’s psyche and skills will undoubtedly cause some challenges and expensive errors, but hopefully an array of aha! moments and profitable success stories as well. It’ll hopefully be an educational and fun journey. I hope that the reports here on the blog will be so, too.

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