How To Call 2 Math Methods On The Same Line What is Value Investing?

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What is Value Investing?

What is value investing?

Different sources define value investing differently. Some say that value investing is the investment philosophy that favors buying stocks that are currently selling at low price/book ratios and have high dividend yields. Others say that value investing is all about buying stocks with low P/E ratios. Sometimes you’ll even feel that value investing has more to do with the balance sheet than the income statement.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We believe that the very term “value investing” is redundant. What is “investing” if not the act of seeking at least enough value to justify the amount paid? Knowingly paying more for a stock than its calculated value – in the hope that it can soon be sold at an even higher price – should be labeled speculation (which is neither illegal, immoral nor – in our opinion – financially fattening).

Appropriately or not, the term “value investing” is thrown around a lot. It typically connotes buying stocks that have attributes such as a low price-to-book ratio, a low price-to-earnings ratio, or a high dividend yield. Unfortunately, these characteristics, even if they appear in combination, are far from determinative as to whether an investor is really buying something for what it is worth, and therefore really works on the principle of getting value in their investments. Consequently, the opposite characteristics – a high price-to-book ratio, a high price-to-earnings ratio and a low dividend yield – are in no way incompatible with a “value” purchase.

Buffett’s definition of “investing” is the best definition of value investing out there. Value investing is buying a stock for less than its calculated value.

Principles of value investing

1) Each share of stock is a stake in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price at a future date. Shares represent more than the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible), and should be valued as such.

2) A share has intrinsic value. The intrinsic value of a stock is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the efficient market hypothesis. They believe that stocks often trade at prices above or below their intrinsic values. Sometimes the difference between a stock’s market price and that stock’s intrinsic value is wide enough to allow for profitable investments. Benjamin Graham, the father of value investing, explained the inefficiency of the stock market using a metaphor. Value investors still refer to his metaphor of Mr. Market:

Imagine you own a small share in some private company that cost you $1,000. One of your partners, named Mr. Market, is very kind. Every day it tells you what it thinks your interest is worth and also offers to buy or sell you an additional interest on that basis. Sometimes their value idea seems plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears escape, and the value he proposes seems a little silly to you.

4) Investing is smarter when it’s more entrepreneurial. This is a quote from Benjamin Graham “The Intelligent Investor”. Warren Buffett believes it is the most important investment lesson he was ever taught. Investors should treat investing with the seriousness and scholarship with which they treat their chosen profession. An investor should treat the stocks he buys and sells like a shopkeeper would treat the commodities he trades. He should not make compromises when his knowledge of the “merchandise” is insufficient. In addition, he must not engage in any investment transaction unless “a reliable calculation shows that it has a fair chance of producing a reasonable profit.”

5) A true investment requires a margin of safety. A margin of safety may be provided by a company’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of previous ones The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety should be as wide as humans are stupid (that is, it should be a real chasm). Buying ninety-five cent dollar bills only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to be profitable even for mere mortals like us.

What is not value investing

Value investing is buying a stock for less than its calculated value. Amazingly, this fact alone separates value investing from most other investment philosophies.

Real (long-term) growth investors like Phil Fisher focus solely on the value of the business. They don’t care about the price paid, because they only want to buy shares in truly extraordinary businesses. They believe that the phenomenal growth these companies will experience for many years to come will allow them to benefit from the wonders of compounding. If the company’s value rises fast enough and the stock holds long enough, even a seemingly high price will be justified.

Some so-called value investors do consider relative prices. They make decisions based on how the market values ​​other public companies in the same industry and how the market values ​​each dollar of earnings present in all companies. In other words, they may choose to buy a stock simply because it looks cheap relative to its peers, or because it trades at a lower P/E ratio than the general market, even though the P/E ratio may not seem particularly low . in absolute or historical terms.

Should this approach be called value investing? I do not think so. It may be a perfectly valid investment philosophy, but it is different investment philosophy.

Value investing requires the calculation of an intrinsic value that is independent of the market price. Techniques that rely solely (or primarily) on an empirical basis are not part of value investing. The principles expounded by Graham and expanded upon by others (such as Warren Buffett) form the basis of a logical edifice.

While there may be empirical support for value investing techniques, Graham founded a very logical school of thought. Correct reasoning emphasizes testable hypotheses; and causal relationships are emphasized over correlative relationships. Value investing can be quantitative; however, it is arithmetically quantitative.

There is a clear (and pervasive) distinction between quantitative fields of study that use calculus and quantitative fields of study that remain purely arithmetic.. Value investing treats security analysis as a purely arithmetical field of study. Graham and Buffett were known to have stronger natural mathematical skills than most security analysts, and yet both men claimed that using higher mathematics in security analysis was a mistake. Real value investing requires nothing more than basic math skills.

Contrarian investing is sometimes considered a sect of value investing. In practice, so-called value investors and so-called contrarian investors tend to buy very similar stocks.

Consider the case of David Dreman, author of “The Contrarian Investor.” David Dreman is known as a contrarian investor. In his case, it’s an appropriate label, given his keen interest in behavioral finance. However, in most cases, the line separating the value investor from the contra investor is fuzzy at best. Dreman’s contrarian investment strategies are derived from three measures: price to earnings, price to cash flow, and price to book value. These same measures are closely associated with value investing, and especially so-called Graham and Dodd investing (a form of value investing named after Benjamin Graham and David Dodd, the co-authors of “Security Analysis”).

Conclusions

Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the stock’s value is truly independent of the stock market.. When intrinsic value is calculated using an analysis of discounted future cash flows or asset values, the resulting estimate of intrinsic value is independent of the stock market. But a strategy that is simply based on buying stocks that are trading at low price-to-earnings, price-to-book and price-to-cash-flow multiples relative to other stocks is not value investing. Of course, these same strategies have proven to be quite effective in the past and will likely continue to work well in the future.

The Magic Formula devised by Joel Greenblatt is an example of an effective technique that will often result in portfolios that resemble those built by real value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the shares purchased. So, while the magic formula may be effective, it is not a real value investment. Joel Greenblatt is a value investor himself, because he calculates the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book That Beats The Market for an audience of investors who had neither the ability nor the inclination to value companies.

You cannot be a value investor unless you are willing to calculate business values. To be a value investor, you don’t need to accurately value the business, but you do need to value the business.

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