I’ve been reading some Graham and Buffett lately and thought I’d write a post about what both call the fundamentals of value investing.
1. You are buying a business not a stock.
When buying a stock you are buying a small piece of a real business (hopefully).
Ask yourself, what is the intrinsic value of the whole business and, given that value, is the current market price of the stock a bargain or not?
Stock prices fluctuate wildly in any given time-frame but the underlying economic value of the company does not change as rapidly.
2. The market is not efficient.
And thank God it isn’t.
There are many reasons why value investors argue the market is not efficient but two main ones are:
- Information and knowledge are not the same thing. Just because a lot of information is in the market-place and people have access to it does not mean they actually know what it means or what its relevance is.
- People have emotions and they often make investment decisions based on those emotions as opposed to “ideal” rational calculations of business value.
The lack of a perfectly efficient market is fundamental to any value investing strategy.
If you believe markets are perfectly efficient there is no reason to spend your time trying to spot discrepancies between price and value.
3. You don’t know everything and never will, so make sure you have a large margin of safety.
If you tried to analyze every piece of information about even 1 company you would probably never get around to investing in it. As such, having a margin of safety is crucial when value investing.
No matter how much research you do, when dealing with a business in our complex economy you will probably either overlook and/or fail to anticipate factors relevant to calculating the business’ intrinsic value.
Using a margin of safety is your acknowledgement of this reality.
If, after careful consideration, you think the stock is worth $10 a share, buy it for $5 or less.
For more on value investing try The Intelligent Investor and Security Analysis by Benjamin Graham, Warren Buffett’s annual letters to Berkshire Hathaway, Inc. shareholders,[1] and Janet Lowe’s Warren Buffett Speaks: Wit and Wisdom from the Word’s Greatest Investor.
[1] http://www.berkshirehathaway.com/letters/letters.html. I would highly you recommend you read every last one of these. You won’t get an MBA but you may end up rich.
