Value investors don’t believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account, so their price always reflects their value. Instead, value investors believe that stocks may be over- or underpriced for a variety of reasons.
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Understanding Value Investing
The basic concept behind everyday value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.
Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuations—but that doesn’t change what you’re getting for your money.
Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won’t go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.
Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long term, investors can be rewarded handsomely.
Why invest in value stocks?
Everyone likes a bargain, and because value investing seeks stocks selling at a discount to their intrinsic value, the investment strategy appeals to those who like to get good deals. All it takes to make money with a value stock is for enough other investors to realize there’s a mismatch between the stock’s current price and what it’s actually worth. Once that happens, the share price should go up to reflect the higher intrinsic value. Then those who bought in at a discount will get their profit.
Furthermore, many investors like the margin of safety provided by a stock that’s purchased for less than what it’s inherently worth. There’s no guarantee the stock price won’t fall further, but it does make additional share-price declines less probable and less dramatic.
For those who see themselves as defensive investors without much tolerance for risk, a good value stock can provide both protection against losing money and the potential to cash in once the stock market recognizes the stock’s true value.
Value investing can require patience because it often takes a long time for a value stock to get repriced at a more appropriate and higher level. For those willing to wait, however, the returns can be quite sizable.
Who are the two most famous value investors?
Benjamin Graham is generally regarded as the father of value investing. Graham’s Security Analysis, published in 1934, and The Intelligent Investor, published in 1949, established the precepts of value investing, including the concept of intrinsic value and establishing a margin of safety.
Besides those two invaluable tomes Graham authored, his most lasting contribution to value investing was his role in setting the stage for legendary investor Warren Buffett. Buffett studied under Graham at Columbia University and worked for a short time at Graham’s firm.
As the CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) , Buffett is perhaps the best-known value investor. Buffett cut his teeth in value investing in his early 20s and used the strategy to deliver immense returns for investors in the 1960s before taking control of Berkshire in the 1970s.
However, the influence of Charlie Munger, Berkshire’s vice chairman and Buffett’s investing partner for many decades, along with Buffett’s evolution as an investor, has changed Buffett’s strategy. Instead of purely buying undervalued assets, Buffett shifted to identifying high-quality businesses at reasonable values.
What Is a Value Investment?
Value investing is an investment philosophy that involves purchasing assets at a discount to their intrinsic value. This is also known as a security’s margin of safety. Benjamin Graham, known as the father of value investing, first established this term with his landmark book, The Intelligent Investor, in 1949. Notable proponents of value investors include Warren Buffett, Seth Klarman, Mohnish Pabrai, and Joel Greenblatt.
Common sense and fundamental analysis underlie many of the principles of value investing. The margin of safety, which is the discount that a stock trades at compared to its intrinsic value, is one leading principle. Fundamental metrics, such as the price-to-earnings (PE) ratio, for example, illustrate company earnings in relation to their price. A value investor may invest in a company with a low PE ratio because it provides one barometer for determining if a company is undervalued or overvalued.
Who Is Mr. Market?
First coined by Benjamin Graham, “Mr. Market” represents a hypothetical investor that is prone to sharp mood swings of fear, apathy, and euphoria. “Mr. Market” represents the consequences of emotionally reacting to the stock market, rather than rationally or with fundamental analysis. As an archetype for her behavior, “Mr. Market” speaks to the price fluctuations inherent in markets, and the emotions that can influence these on extreme scales, such as greed and fear.
Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).
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