Lesson #3: Being a Value Investor
Value investing has been around since the beginning of market and investing history. Yet, especially before 2002, it has had relatively low visibility.
As more individual investors jumped on board in the late 1990s, people were more excited more by the go-go world of trading and aggressive growth investing. More intrigued by companies that make software codes and network routers than by companies that sell paints and soaps.
While boring to some, the value investing approach has earned strong returns for its faithful followers, often far beyond market averages for good stock pickers. Value investing has brought prosperity in healthy markets and survival during the numerous downturns throughout the twentieth century.
But what exactly does it mean to be a value investor?
At its most basic level it means seeking out stocks that you believe are worth considerably more than you have to pay for them. But all investors try to do that!
In reality, value investing is both a mindset as well as a rigorous discipline.
Charlie Munger defined it as – “All intelligent investing is value investing — acquiring more than you are paying for.”
So, value investing equals intelligent investing.
But ask anyone who has a faintest idea about value investing, and the general view is that it is same as bottom fishing, or buying cheap stocks – those that are trading at low price to earnings (P/E) or low price to book value (P/BV).
This is far from truth. Value investing is much more than buying cheap stocks.
As Munger said…
You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.
So while “investing” is about buying cheap stocks, “value investing” is about knowing clearly what you are buying.
Benjamin Graham, the father of value investing, stated in his book Security Analysis (called the “Bible of Value Investing”)…
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
What this definition implies is that if you don’t have proper data and reasoning associated with an appropriate price tag (cheap stock), it isn’t value investing.
After all, everyone is looking to buy low and sell high. So what is it that differentiates real value investors, who are actually quite rare, from all the others who trade in the stock market?
Value Investing is…Difficult!
Making money on “cheap” stocks – which is the goal of every value investor – is harder than it sounds and can take years to play out.
In fact, identifying a cheap stock and buying it is a relatively easier proposition. But value investing is difficult simply because…
- You need to have patience, and a lot of it
- You must be disciplined
- You must mind your behaviour
- You must know when to go against the crowd
- You must read a lot (annual reports, investing books etc.)
In all, value investing requires hard work. This is probably the reason you won’t find many value investors out there.
But whoever has had the patience to practice value investing in its real form, has done wonders for his stock portfolio.
How to Become a Value Investor?
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote…
We think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labelled speculation (which is neither illegal, immoral nor – in our view – financially fattening).
Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.
Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.
So it’s the ‘process’ of picking up bargain stocks that value investing is all about.
You must know what you are getting into. That’s exactly what we are going to learn in this course over the next few months.
“Most people aren’t cut out for value investing, because human nature shrinks from pain.”
Not me, that’s what a leading money manager in the US Jean-Marie Eveillard says.
I believe his words are a great reminder that making money on cheap stocks, which is the goal of every value investor, is harder than it sounds and can take years to play out.
Value investing, on the face of it, seems easy. Just read about a business, calculate its intrinsic value in an excel sheet using pre-determined formulae, and if the stock price is much lower than that intrinsic value, buy the stock or else avoid it.
Theoretically, this is true.
But then, as Yogi Berra says, “In theory there is no difference between theory and practice. In practice there is.”
So, while learning about value investing isn’t difficult, putting the learning into practice is.
I have realized over my ten years of being an investor that the long-term rewards don’t go to people who think value investing is easy.
The reality is that superior returns can be earned only by those who know that it is hard – and still stay put.
But the way most “value” investors behave is very different. In fact, a lot of people start out as “value investors”, then get upset seeing their returns after one bad year, get mad after two years, and gone after three!
A lot of experts would tell you that a great stock picker can “always” outperform the market.
However, ironically, investors who buy into this myth often sell in a panic as soon as the next crash proves that no stock picker can “always” outperform.
So what makes for a true value investor apart from just finding businesses that are selling cheap?
A lot, I believe.
What Makes for a Good Value Investor?
Noted American investor, Whitney Tilson, in his recent book called “The Art of Value Investing: How the World’s Best Investors Beat the Market” suggests thirteen key characteristics that make up a true value investor.
He writes that value investors typically…
1. Focus on intrinsic value. What a company is really worth – buying when convinced there is a substantial margin of safety between the company’s share price and its intrinsic value and selling when the margin of safety is gone. This means not trying to guess where the herd will send the stock price next.
2. Have a clearly defined sense of where they’ll prospect for ideas, based on their competence and the perceived opportunity set rather than artificial style‐box limitations.
3. Pride themselves on conducting in‐depth, proprietary, and fundamental research and analysis rather than relying on tips or paying attention to vacuous, minute‐to‐minute, cable‐news‐style analysis.
4. Spend far more time analyzing and understanding micro factors, such as a company’s competitive advantages and its growth prospects, instead of trying to make macro calls on things like interest rates, oil prices, and the economy.
5. Understand and profit from the concept that business cycles and company performance often revert to the mean, rather than assuming that the immediate past best informs the indefinite future.
6. Act only when able to draw conclusions at variance to conventional wisdom, resulting in buying stocks that are out‐of‐favor rather than popular.
7. Conduct their analysis and invest with a multiyear time horizon rather than focusing on the month or quarter ahead.
8. Consider truly great investment ideas to be rare, often resulting in portfolios with fewer, but larger, positions than is the norm.
9. Understand that beating the market requires assembling a portfolio that looks quite different from the market, not one that hides behind the safety of closet indexing.
10. Focus on avoiding permanent losses rather than minimizing the risk of stock‐price volatility.
11. Focus on absolute returns, not on relative performance versus a benchmark.
12. Consider stock investing to be a marathon, with winners and losers among its practitioners best identified over periods of several years, not months.
13. Admit their mistakes and actively seek to learn from them, rather than taking credit only for successes and attributing failures to bad luck.
As it comes out clear from Tilson’s view, at its most basic level, being a value investor it means seeking out stocks that you believe are worth considerably more than you have to pay for them.
But all investors try to do that!
Thus, as Tilson also adds, it’s also about behaving well, which involves…
- Accepting mistakes
- Learning from others
- Thinking long term
- Focusing on risk more than return
- Respecting business and stock market cycles
- Being contrarian
Value Investing is Not Esoteric
There is nothing esoteric about value investing.
As we have understood from the above points, it is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple.
The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.
You see, the focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.
If you consider the large, institutional investors, they are usually evaluated – and therefore measure themselves – on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers.
Value investors, by contrast, have as a primary goal the preservation of their capital.
It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.
A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.
It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.
Here is what Seth Klarman writes in his Margin of Safety…
If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public’s favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.
The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.
Value investors invest with a margin of safety that protects them from large losses in declining markets. Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines.
Unfortunately, many more investors claim the ability to foresee the market’s direction than actually possess that ability. (I myself have not met a single one.)
Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.
All Intelligent Investing is Value Investing
Looking at the above pre-requirements of being a value investor, it comes out clear that apart from a quantitative aptitude – ability to understand numbers – you must have the intelligence and sensibility to behave well in your act as an investor.
But this has been said for years. In fact, Ben Graham talked about sensible behaviour in investing in 1949 when he released his seminal book – The Intelligent Investor. Then, Buffett and Munger have been stressing upon this for years.
So why do most investors don’t behave sensibly? And also, if most people appreciate sensible behavior, why are most people not value investors?
Here’s Buffett explaining why…
It’s Human Nature, Stupid!
The reasons most investor aren’t value investors are deeply rooted in human nature – and, therefore, unlikely to ever change.
We are averse to losses. We perceive the pain of a loss about twice as strongly as the pleasure of a comparable gain.
Due to its contrarian bent, value investing can sometimes fail to work for long periods of time, causing plenty of pain. To avoid such an outcome, most of us would get drawn into a sucker’s game of rapidly trading our portfolios rather than waiting out the inevitable periods when they don’t perform well.
Then, value investing is a get-rich-slowly approach, even as we are all hard-wired to pursue actions that offer immediate gratification.
Finally, we find it hard to go against the crowd. If you didn’t own real estate and infrastructure stocks during the late 1990s, not only did you suffer lousy returns, but you also felt excluded!
Going against the crowd is equivalent to going against the ‘norm’ or being ‘abnormal’, which is not easy to do, and this you won’t find many true value investors out there.
You Have Less Competition
Because of all reasons I mentioned above, you have very less competition in becoming a value investor…a true value investor.
Value investing is less dramatic (Who wants to read those boring annual reports?), and would thus never attract the crowd.
But if you were to walk down this road less travelled, you will not just compound your money safely over the long run but also sleep well at night.
So, I would say that investing is easy, and you can learn it in a few hours. But investing sensibly and successfully is very hard.
Like it’s hard to pick up Graham’s The Intelligent Investor and read it at least three times.
If you haven’t done it, read and re-read this book if you want to better understand the value investing mindset.
Before I end, here are a few words from the legendary Howard Marks of Oaktree Capital on what it means to be a value investor…
I’ve heard it said many times that value investing is not as much about doing smart things as it is about not doing dumb things. Avoiding mistakes, resisting market fads, and focusing on allocating capital into ideas that are highly likely to produce satisfactory returns and that offer a margin of safety against permanent capital loss – these are the dominant themes of the value investing approach.
Contrary to how it sounds, these elements don’t make value investing easier than other approaches. In fact, cultivating the discipline to avoid unproductive decisions, refining the craft of valuing businesses and assessing risk, and developing the emotional and mental equilibrium
required to think independently in a field in which there is tremendous pressure to conform requires constant diligence and effort.
Long-term-oriented value investors have greater scope to produce superior risk-adjusted returns when the seas are rocky. The valid response when there’s chop is to focus on the end destination — what value investors call intrinsic value — and not worry about whether the next wave is going to push the boat up or down.
If you don’t invest with a very clear notion of underlying value, how do you do it? Nothing else makes sense.
Your ability to maintain focus on the long term comes from experience. You go through a couple cycles where everybody else is screaming at you not to try to catch a falling knife, and then when you do so and make some money, it does wonders for you…and for your ability to do it next time.
Here I repeat what Marks says, and how it gels so well with Tilson’s points about being a value investor…
- Value investing is not as much about doing smart things as it is about not doing dumb things.
- You must learn to avoid mistakes.
- You must resist market fads.
- You must focus on allocating capital into ideas that are highly likely to produce satisfactory returns and that offer a margin of safety against permanent capital loss.
- Value investing isn’t easy to practice, as you require constant diligence and effort to cultivate the discipline to avoid unproductive decisions and develop the emotional and mental stability.
- But if you can do this, you have a great scope to produce superior risk-adjusted returns over the long run.
- Your ability to maintain focus on the long term comes from experience.
You see, the tools and analyses for value investing may change over time, but the mindset remains the same.
If you can create the right mindset to become a value investor and then practice it with diligence, it would indeed be an investing life well-lived.
Finally, in any event, reading all this and working on this Course alone will not turn you into a successful value investor.
As I mentioned above, and as Buffett, Marks, and Klarman have been saying for years, value investing requires a great deal of hard work, strict discipline, and a long-term investment horizon.
Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of
those have the proper mind-set to succeed.
Plus, there is a risk of being seduced, and no style is immune to mistakes.
This Course most certainly won’t provide you a surefire formula for investment success. There is, of course, no such formula.
Rather I intend to help you with a blueprint that, if carefully followed, offers a good possibility of investment success with limited risk.
I believe this is as much as you can reasonably hope for. 🙂