Prices in themselves are not appropriate determinants of value, this is one of the core principles of value investing and after examining this idea thorougly, you’ll see this principle cannot be denied.
Consider this example
If I went to a store and got two items one for $40 and the other for $90 dollars. You can’t answer the question “which was the better buy?” without at the very least knowing what each item is. If I told you I got a pair of socks for $40 dollars and a $90 dollar tuxedo suit, then you can make a decision. I have probably overpaid for the socks and got a bargain on the suit.
If we agree with this analogy in other markets why not in the stock market?
The value investing philosophy was pioneered by Benjamin Graham and has been popularly put to great use by Warren Buffett (who needs no introduction). The core ideas behind this philosophy can be summarised as follows:
- Price does not always equal value
- The price you pay for something is only relevant in relation to its value
- The essence of value investing is to purchase shares of a company at a price that is substantially lower than the company’s underlying value.
Margin of Safety
Margin of safety represents the difference between a company’s stock price and the company’s value.
Value investors believe that a large margin of safety provides greater return potential as well as a greater degree of protection over the long term.
When the stock price of the company falls sufficiently below the intrinsic value, it creates a buying opportunity. Value investors expect that over time, as others recognize the true value of the company, its share price will climb toward its intrinsic value. As this happens, the margin of safety shrinks. When the share price equals or exceeds the company’s intrinsic value, the margin of safety has disappeared and the shares should be sold.
What about Growth Investing?
In truth growth investing and value investing have more in common than apart, the major difference lies in the emphasis on “margin of safety”.
A value investor buys stocks on bargain ensuring that the moment he enters a trade, he is already at a profit. Growth investing however focuses on capital appreciation above all, therefore even if a stock isn’t cheap, if it has the potential to increase in value/price in future a growth investor is satisfied.
Value investing vs Speculating
Benjamin graham defines an investment operation as “one which, upon thorough analysis, promises safety of principal and an adequate return.”
Based on this definition, there are three components to investing:
- Thorough analysis,
- Safety of principal
- Adequate return.
Any operations not meeting these requirements according to Graham should be considered speculative.
Investor Charles.H.Brandes expanded on this definition by adding that speculation is:
- Any purchase any based on anticipated market movements or forecasting.
- Having a holding period shorter than a normal business cycle (typically 3 to 5 years)
The problem with speculating is: Who can predict what a third party will pay for your shares today, tomorrow, or any day? Stock market prices typically swing between extremes, stoked by the irrational emotions of fear and greed.
Criticisms of Value Investing
On paper, the logic of value investing may appear obvious: buy stocks at a bargain price and sell them after the price has gone up. However investment decisions are not that straightforward, an investor is subject to an ever-changing environment where logic can be overshadowed by emotion.
It takes a great deal of conviction to stick to value-investment disciplines, especially when a company’s stock price declines after you purchase its shares.
This is why value investor’s trade long-term (3-5 years).
Value investing principles are therefore majorly unappealing to short term traders.
What do you think about value investing?
Which investment strategy do you prefer? Comment below.