Value investing is a much used phrase and means, in general terms, buying something for less than it is worth. It can apply to just about anything. You can value invest in shares, in bonds, in property, in postage stamps, in vintage cars. The difficulty is in calculating the value of the thing in which you are investing. In many things (postage stamps, collectible cars etc), the only way that value can be determined at any given time is the price that someone is prepared to pay for the item at at that time. The investor in that asset is, as a result, subject to the opinion of others.
Benjamin Graham proposed a method of calculating the value of a stock and Warren Buffett has both applied and enhanced Grahamâ€™s approach.
Benjamin Graham: the ‘father of value investingâ€™
It was Benjamin Graham who applied to the theory of investing the concept of intrinsic value. According to Graham, if you can determine the intrinsic value of a share, then you can ascribe to that share a real value that is not dependent upon the opinion of others (the whims of Mr Market). If you can then buy that share at a price less than its intrinsic value, giving yourself a satisfactory margin of safety, you have made a prudent and rational investment. An investor who holds a diverse portfolio of stocks acquired by this process should, over time, finish ahead.
Benjamin Graham did not apply the term value investment to this investment approach; that has been done by others. He did however called this intelligent investing, indeed the only real form of investing. Buying shares on the basis of value is investing. Buying shares on other bases such as the belief that the market will rise generally, or that a particular industry is good, or that others will bid the price up, is not investment but speculation.
Grahamâ€™s basic principles of value investing
In The Intelligent Investor, Graham sets out his strategies for making investments based on value for various types of investor - passive and active, defensive and enterprising - but each approach rests on these basic principles:
- When you buy a stock, you are buying a share in a business.
- The market price of a stock is only an opinion of the value of the stock and does not necessarily reflect the real value of that stock.
- The future value of a stock is a reflection of its current price.
- An investor must always build a margin of safety into the decision to buy a stock.
- Intelligent investing requires a detached and long term approach, based on careful research and reason, and not on the opinions of others or the prospects of short term gains.
Warren Buffett and value investing
The fact that Graham suggested different strategies for what he called defensive investors and enterprising (and more enterprising) investors does not mean that value investments and growth investments are mutually exclusive. Warren Buffett has shown that you can value invest in shares that grow over time. He has always acknowledged that his investment style is based on Benjamin Grahamâ€™s principles and he cannot understand why all investors donâ€™t do the same thing. In March 2012, Buffett told a group of MBA Â students that:
The principles of value investing have not changed from the teachings of Ben Graham until now.
Buffett identified for the MBA students the two factors that mark the value investor: a long term perspective and the patience to not seek to get rich overnight: value investors are not concerned with getting rich tomorrow but over a ten year period instead.
There is nothing wrong with getting rich slowly.
But Buffett has added his own riders to Grahamâ€™s tenets and to some extent introduced a subjective element to the objectivity of Graham, particularly in his preference for businesses with a competitive advantage.
He gave the MBA students his (and our) favorite example Â -Â Coca Cola. He explained that people will go on drinking Coke because they like it; possible loss of markets in the Western world because of health concerns or competition is more than made up by new customers in other countries; the company has been doing the same thing for many years; it sticks to its core business; and if it decides to add a cent or two to the sale price of a Coke to adjust for inflation or to cover any loss of margins, nobody is going to stop drinking it.
At various times, Buffett has decided that Coke has fallen below its intrinsic value and stepped in and bought shares - that is value investing.
Buffett sums up value investing
When Buffett was asked to explain his investment strategy, the words that he used essentially reflect the essence of value investing: look at a stock, assess its value, work out a price that you can pay for it with a minimum of risk, wait patiently for that price and then buy in when you can. Buffett said:
Invest in equities slowly over time … And look to buy companies that will go on forever like Coca Cola … but the key is to buy equities slowly over time and donâ€™t try to time the market. For the more serious investor, buy equities strategically, opportunistically.