Value Investing
Value investing is the art of finding great stocks at fair prices instead of overpaying. It’s about looking for companies that are worth more than their current stock price, based on their earnings, assets, and potential. The goal is to buy them when they’re undervalued and wait for the market to catch up, rewarding patient investors over time.
Finding Order in the Chaos
During the Great Depression and the years that followed, the stock market was in turmoil. Investors were gripped by fear, and widespread panic led to extreme volatility. The market seemed unpredictable, with stock prices swinging wildly and businesses crumbling left and right. For many, it appeared that the market was driven purely by emotion and chaos, with no real sense of direction or rationality.
In the midst of this uncertainty, Benjamin Graham saw an opportunity. Rather than being swept up in the panic, he began to look for patterns and order in what seemed like a random, chaotic environment
Price Follows Value
In his book The Intelligent Investor, Benjamin Graham emphasizes a fundamental concept in value investing: that the price of a stock ultimately follows the value of the business behind it. Stocks are not just random numbers—they represent real businesses with tangible assets, earnings potential, and future prospects. The value of these businesses is what makes a stock desirable or not.
The chaotic nature of the market is a reflection of investors digesting a constant flow of information—about the company, the economy, and global events. In the short term, this leads to confusion, mistakes, and volatility as people react impulsively to news and rumors. Stock prices swing dramatically, often far from a company’s intrinsic value. However, over the long term, as investors refine their understanding and more accurately assess a company’s true worth, the market begins to align the stock price with that value. In this way, price truly follows value, proving that patience and a focus on fundamentals can overcome short-term chaos.
Do Not Overpay
Understanding the intrinsic value of a stock is the cornerstone of effective investing. Intrinsic value represents what a stock is truly worth, based on its fundamentals, independent of its current market price. The primary goal for investors is to acquire stocks when they are priced below this intrinsic value, ensuring a margin of safety and potential for profit. This principle extends beyond stocks to any purchase in life, where value must justify the cost. For instance, while garlic provides essential nutrients and flavor, buying it for 2,000 pesos per kilo would be a poor value proposition. Similarly, a reliable car like a Toyota Fortuner becomes a bad deal if priced at 10-15 million pesos.
In investing, finding great companies is not enough; the key lies in paying the right price for their stocks. Overpaying can turn even the most promising investment into a poor decision, as highlighted by renowned investor Howard Marks. Therefore, successful investing requires the ability to accurately assess intrinsic value and the patience to wait for opportunities when stocks are undervalued. By adhering to this disciplined approach, you ensure that your investments provide true value and minimize the risk of overpayment, optimizing your potential returns.
Intrinsic Value Methods
In the beginning, Ben Graham conducted extensive analysis on the Price to Book Ratio, a close estimation of a company’s liquidation value, placing emphasis on paying much less than the amount a company would liquidate for. This was a good strategy during the Depression, as many companies closed due to uncertainties.
Today, company closures are rare, and there are many models and methods to choose from. These range from simple multiples, such as the P/E ratio, EV to EBIT, and still Price to Book, to more traditional approaches like DCF on a company’s free cash flow, applying DCF on dividends, the Gordon Growth Model, or simply looking at dividend yield. The key is to learn these different methods and apply them according to each company’s specific situation.
Risk Management
In investing, the most important thing to focus on is managing risk. This means trying to avoid losses by reducing mistakes, as making too many mistakes can hold you back. While tools like stop-loss orders and spreading your investments around (diversification) are great ways to manage risk, the first thing you should do is make sure you’re not paying too much for stocks.
When you buy stocks for less than they’re really worth, you’re protecting yourself from big losses. If you overpay, there’s a risk the stock’s price will drop to its actual value, which can lead to losing money. But if you buy at a low price, there’s less chance of the price falling further, which helps manage risk right from the start.
Achieving Potentially Excellent Returns
As discussed above, it’s important to understand that prices often move toward their true value over time. If a stock’s price is much higher than what it’s actually worth, it’s likely to come down. On the other hand, if the price is much lower than its true value, it’s likely to go up. This is why finding good companies at low prices is key.
By focusing on buying these undervalued stocks, we give ourselves a better chance to make great returns. The more we look for these bargains, the more potential we have to earn excellent returns in the long run. Investing with this mindset helps us take advantage of the natural tendency for prices to eventually match their true value.
