Value investing is a style of investment developed in 1928 at Columbia University by Benjamin Graham and David Dodd. It is based on acquiring stocks at a discount to their intrinsic value (perception/estimation of true value), taking advantage of short-term fluctuations to invest in the long term, since market prices do not always correspond with long-term fundamentals (qualitative and quantitative information about a company).
The term ‘value investing’ has usually been used in the wrong way. Many people think that it implies the purchase of stocks with attributes such as a low price-earnings ratio (current company price relative to its earnings) or a high dividend yield. These characteristics do not determine whether an investor is obtaining more value than the price he is paying.
Warren Buffett, possibly the best investor ever, has quoted John Burr Williams’ sentence of his book The Theory of Investment Value : “The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset” (Williams, 1938). In other words: The value of a company should reflect the amount of cash it will generate over its lifetime.
We seek to invest in well positioned companies with strategic improvement potential and partner with management teams to create value.
The Intelligent Investor
Warren Buffett, a disciple of Benjamin Graham, has described The Intelligent Investor (1949), written by Benjamin Graham, as “by far the best book on investing ever written”. According to Buffett, “if you follow the behavioral and business principles that Graham advocates – and if you pay special attention to the invaluable advice in Chapters 8 and 20 – you will not get a poor result from your investments. Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investing career” (Buffett, 1984). Vadevalor recommends everyone reading this book before making any investment decision.
Investment & Speculation
According to Graham, what differentiates an investor from a speculator is the attitude towards stock market movements. The speculator will try to profit from market fluctuations and the investor will want to acquire and hold suitable securities at suitable prices.
We could get into more details as Warren Buffett did when he stated that the investor seeks returns from the underlying asset itself, committing some funds now to get more funds later through the operation of the asset. The speculator focuses on the price action of the stock.
Margin of Safety
The difference between the intrinsic value and the value indicated by the market. The secret of sound investment from Benjamin Graham is the margin of safety. It is important to have a margin of safety to reduce the negative effect of miscalculations.
Pricing & Timing
There are two ways to take advantage from fluctuations in common stocks: timing and pricing.
‘Pricing’ is about buying or holding stocks when the price is below their fair value and selling them them when the price rises above that value.
‘Timing’ is the strategy of attempting to anticipate to the future direction of the market. This is done by either buying or holding when prices are going to increase and selling when prices are about to decrease.
The intelligent investor can obtain highly successful returns with ‘pricing’. On the contrary, Graham considers investors can never believe any of the predictions about future directions of the stock market.
Investors and businessmen should not refrain from buying a wonderful business because of short-term worries about the economy.
“Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.” (Buffett, 1994).
Book Value & Intrinsic Value
Intrinsic value and book value are different concepts. Book value is a company’s stock equity as it is represented on the balance sheet. It is an accounting concept, which takes into account the accumulated financial input from contributed capital and retained earnings.
Intrinsic value is the estimation of future cash output discounted to the present. It is an economic concept. It is per-share intrinsic value what matters.
Book value indicates what has been put in and intrinsic value indicates what can be taken out. Therefore, business with the same financial input can have different valuations.
Efficient Market Theory
The efficient market theory says that all the information about companies is already reflected in stock prices so analyzing stocks is useless. So someone choosing random stocks would have the same probability of success as the most hard-working security analyst.
It is a huge advantage for value investors to have competitors who have been taught that it is not worth trying to analyze companies.
The stock market is very liquid, that is, investors can buy or sell their shares at the market price when they wish as if a man named Mr. Market offers buying and selling shares at a specific price.
Sometimes, Mr.Market valuations are reasonable, however, they are normally either too low or too high. An intelligent investor will be happy to buy from him when the price is low and sell to him when the price he offers is high.
Stock prices are determined by supply and demand from a large number of investors. This is the reason why sometimes it is possible to buy portions of businesses at a much lower price than the price paid for a company acquired through an acquisition.
Inflation is defined as the increase in the general level of prices for goods and services.
In 1949, at the time Benjamin Graham wrote The intelligent investor, in the United States people were aware they had to fight against inflation. This was due to the shrinkage of the purchasing power of the dollar in the past and the fear of a severe decline in the future.
Stocks have advantages against bonds since they had offered a considerable degree of protection against depreciation of the currency caused by inflation and bonds do not offer any protection (because the interest they offer is not adjusted by inflation).
If inflation ever goes out of control, the best place to keep the purchasing power of the assets is in equities. Germany in the 1920s and Argentina after its 2002 devaluation are good examples of this phenomenon. The stock market of those countries rose considerably during those periods. It makes sense since companies can set a higher price for their goods or services when there is inflation. Cash depreciates and fixed-income securities, whose value is set in nominal terms also lose value.
According to this theory, fractional reserve banking continually generates economic crises. This is due to the fact that in periods of credit expansion, banks generate new liquidity which is invested without any prior saving (giving more loans with respect to its deposit base).
The interest rate becomes lower than one that would have predominated in the market without a credit expansion, which results in new investments in capital intensive projects. Entrepreneurs launch new investment projects as if society had increased their savings.
However, many of those projects financed by the banking system end up not being profitable, so many companies go bankrupt and this damages banks.
In periods of monetary expansion, the monetary supply increases through the multiplier effect, but an inevitable contraction starts after this artificial expansion as new defaults and loan repayments reduce the monetary supply. At the same time, the value of the assets in the banking system also goes down.
Some investors said they could avoid investing in some sectors before the 2008 financial crisis thanks to this economic theory. Francisco García Paramés highlights that it is the right framework to understand economic and even social events.
As we can see, the Austrian school considers that economic cycles are caused by bad investments when interest rates are artificially low.
For further details, we recommend reading the book Money, Bank Credit and Economic Cycles written by Jesus Huerta de Soto. Regardless of political and economic ideology, this book is extremely useful to understand how the actual banking system works. In addition, it explains it in a surprisingly simple way, starting with the history of banking crises.