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.”

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