Benjamin Graham: Graham is considered the father of Value Investing. The book 'The Intelligent Investor' remains a classic today.
Recently, I've created two series of blog posts arguing against the two most popular investment philosophies of today.
In the first series, I argued against the efficient market hypothesis - i.e. the idea that the markets are completely rational, and therefore it's impossible to outsmart them.
In the second series, I argued against dividend investing - i.e. the idea that higher yielding dividend stocks give you superior returns relative to their risk.
Now that you know what I'm against, you might ask which philosophy I actually stand for. Well, the answer is simple.
I'm for value investing.
Definition of Value Investing
It's easy to define value investing, but it's also easy to misunderstand the notion. I personally define it as the art and science of first finding the true value of an investing opportunity, and then investing in the undervalued opportunities. Buffett stated it more eloquently - It's about "buying $1 bills for 40 cents"
To give you an example, let's say I do some research on Ford. I read the financial statements. I think about Ford's competitive advantage, which helps me imagine what Ford might look like in 10 years time. I think about a dozen other factors, and conclude that Ford is worth $20. But I find that the stock is trading at $12, so I buy. (Please note, I'm not saying I think Ford is worth $20).
Sounds simple enough, doesn't it? So why is it so often misunderstood? It's all encompassed in the definition of 'true value'.
Discounted Cash Flow Model
The discounted cash flow model lies at the heart of value investing, because it's really the only rational way to value opportunities. The concept is easy to understand.
Say you bought some Ford stock for $20 a share, and you purposely held onto it forever. What kind of returns would you generate?
Likely, you would receive some dividends. You might also get paid if Ford was taken over by another company, in which case you'd be forced to sell your shares. On the other hand, Ford might go bankrupt. Once you project how much you might receive or lose in the future, and once you take the purchase price into account, you will end up with an estimate of returns you'd expect from holding the stock forever.
For example, if we believe Ford will earn $2 a year and pay all its earnings out in dividends forever, then we would expect to generate 10% per year in returns if we bought Ford stock at $20 a share.
Some stocks and bonds will generate high returns if you hold them forever. Others will generate poor returns. Value investing is about selecting such stocks and bonds where you'd be happy with the returns from holding them until the investment no longer exists.
Discounted cash flow is not the only way to "value" a company, but many of these other methods employ short cuts that don't really reflect a company's true or intrinsic value.
For instance, one very popular ratio is called the Price to Earnings (P/E) ratio. As its name suggests, it measures the price of a stock compared to its earnings. Stocks with lower P/E ratios are generally considered 'cheaper'. Therefore, those who buy stocks with lower P/E ratios might think they're practicing value investing.
Unfortunately, this may not be the case. After all, why do investors look at P/E ratios to start with? It's because P/E ratios give clues as to the kinds of returns one might expect from holding the stock forever.
As you see in this article, the true value of a company may differ greatly from valuations arrived at through the simple use of P/E ratios. The same goes for other metrics of convenience such as P/B (Price to Book ratio), and so forth. That's because ratios like P/E and P/B are just shortcuts, nothing more.
Value vs. Growth Investing
Many people mistakenly believe that value investing is fundamentally different from growth investing. They associate value investing with investing in 'cheap' companies, and people associate growth investing with investing in growing companies.
In fact, true value investing forces us to consider the value of a company given its future earnings potential. Therefore, value investing encompasses the issue of growth, as that is just one component in the way we value companies.
For example, a company that's trading at a high P/E ratio may be 'cheap' from a value investing perspective, if it grows very fast. Conversely, a company that trades at a low P/E ratio may be 'expensive' if it has no growth, or even shrinking earnings.
Are You a Value Investor?
Interestingly, not everybody 'gets' value investing. As Buffett remarked, either the concept of buying $1 for 40 cents appeals to people, or it doesn't. This happens regardless of people's intelligence.
How do you know if you're a value investor? Ask yourself - do you care about the company's long term prospects (over 10 years)? Would you rather focus your efforts on finding the true value of stocks and bonds? If you said yes to these questions, you're likely to be a value investor.
Or, like many other people, would you want to sell any stock you buy within a couple of years? Would you rather anticipate the moves of other people, and act ahead of them? If you said yes to these questions, best of luck to you, and I truly mean that, but you're probably not a value investor.
Why This Matters
The principle of value investing pervades our thinking here at MoneyGeek. We don't let the markets guide us, but rather, we try to make sense of investments in the long run.
Our philosophy affects the way we create our model portfolios - from our choice of stocks and ETFs, to the way we allocate between them. It also affects what we write on our blog and our newsletters. (Just to clear up any potential misunderstanding, this does NOT mean that we recommend actively managed mutual funds).
But no matter what your philosophy is, thank you for checking out our site, and we hope that you'll gain something from reading our blog.