Monday, 2 January 2012

What is Value Investing

Value investing is basically buying a piece of a business at a discount to its value to a private owner. Value investing defines the value of business to its private owner as intrinsic value. The magnitude of discount the stock trades from its intrinsic value is called “margin of safety”. Lets us assume that a tea stall you know is listed. If you think the tea stall is worth Rupees 10K to its owner and the stock market is pricing the tea stall at Rs. 3K, then the difference which is Rs. 7K can be called discount or the margin of safety. You simply should ask yourself a question whether at the current stock price, would you be comfortable buying the entire business? If yes, then you can go ahead and buy the stock. Because each stock represents ownership of a piece of business.

Intrinsic value is not a perfect figure but an estimate. To arrive at the intrinsic value, one needs to look at various factors such as nature of the business, how long has it been in operation, its competitive advantage, its revenues and profit history, the amount of borrowed money it employs, the proportion of the earnings the business retains and the proportion it pays out as dividend, how much of the business the promoters own and whether they are increasing or decreasing their holding.

Depending on how predictable is the earnings of the business you may need more or less margin of safety. For example, suppose you need to check in at the airport early in the morning at 5:00 AM. And the airport is 30 minutes away by taxi. Since you are going very early in the morning there will be little traffic. So you can safely start 45 minutes before check in time, thereby keeping 30 minutes for the commute and 15 minutes as a margin of safety.

However, suppose instead that you need to check in at the airport at 7:00 PM. In this case, the 15 minutes margin of safety discussed earlier is insufficient. The margin of safety now has to account for the rush hour evening traffic. Also you have to keep in mind that it is not easy to get a taxi immediately during rush hours. So you might decide to start 90 minutes before the check in time, thereby keeping 30 minutes for the commute and 60 minutes as a margin of safety.

Greater the margin of safety, better your chances of catching the flight. So, greater the margin of safety, lesser is the risk. But the more the margin of safety you keep, lesser is the efficiency. Because this time could have been productively used doing something better. So greater the margin of safety, lesser is the risk but also lesser is the efficiency.

But the opposite is true in the case of value investing. Suppose a stock is trading at half the intrinsic value of the business. Now, if the stock price falls further, the margin of safety increases and at the same time buying for a lower price increases the potential for return. So greater the margin of safety in value investing, lesser is the risk and greater the potential for return. For instance, in the case of the tea stall example, if the price of the tea stall drops from Rs. 3K to Rs. 2K, the margin of safety increases lowering the risk and increasing the potential for returns.

Some of the famous names in value investing are Benjamin Graham, David Dodd, Warren Buffett, Charlie Munger, Walter Schloss and Mohnish Pabrai.

Here is some recommended value investing resources:

1) The book "The Intelligent Investor" by Benjamin Graham

2) The book “Security Analysis” by Benjamin Graham and David Dodd

3) The book "Common Stocks and Uncommon Profits" by Phil Fisher

4) The book "One Up On Wall Street" by Peter Lynch

5) The book "Beating the Street" by Peter Lynch

6) The speech "The Superinvestors of Graham-and-Doddsville" by Warren Buffett:

7) Warren Buffett's Annual Letters to Shareholders

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