Tuesday, 3 January 2012

Why Value Investing works for its Practitioners

Value Investing is basically buying a piece of business for a discount to its value to a private owner. It is a philosophy followed by some very famous investors such as Benjamin Graham, David Dodd, Warren Buffett and Walter Schloss and it has proved very successful over the long term. One may question that if it is so successful, then why does not everyone follow it? And if everyone follows it, it will no longer be successful because then there will not be any difference between prices and values anymore.

However value opportunities exist because there are some difficulties with value investing.

It takes a particular temperament to follow value investing and not everyone has that. Take Indian Cricket's celebrated batting pair of Gavaskar and Shrikant. Even though Shrikant could see first hand how Gavaskar avoided unnecessary risks, he simply did not have the temperament like Gavaskar and would swing his bat now and then, and sometimes take took much risks. Also playing risky shots would bring about instant reward in the form of boundaries and sixers and also the applause of the crowd.

Some people are more fascinated with glamour rather than substance. To be a value investor you need a personality which values substance over glamour.

Some people take too much debt in good economic times and during bad times when stocks become cheap, they are facing salary cuts and risk of loss of employment and do not have the money and courage to buy stocks. Also some people take debt to buy stocks in good times and have to do a fire sale during bad times further pushing the stock prices further lower.

Value philosophy recommends long term investing but as stock brokers depend on people to trade frequently for a living, they are not likely to recommend it.

Because of the above factors, value investing is not easy and this is what causes value opportunities to arise and remain in the stock market for some time.

For the speculator, a stock is like a lottery ticket or a gamble and hence he will be very conservative about the amount of money he plays with. But to a value investor a stock is a piece of business. Hence, given a good opportunity, a value investor will invest a more significant portion of his net worth and hence get better returns over the long term.

Over the long term, if the underlying business is increasing in value, the stock price is likely to get dragged towards the value of the business making value investing worthwhile.

One of the reasons value investing works for its practitioners is because its opponents believe it does not work; even when they see it working. Many experts believe that the success value investors like Warren Buffett is purely by chance. To quote Warren Buffett “Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

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