Value investing is an investment philosophy that looks at companies’ fundamentals to discover those companies whose intrinsic value is higher than what the market is currently pricing, in short, value investing tries to evaluate a business by starting with its fundamentals.
The man who popularized value investing
You will learn invaluable lessons if you listen to one of many Warren Buffet’s speeches on success. In one of many Buffet’s appearances, he says that success is more than pure intellect or energy.
Accordingly, Buffet believes that integrity is the mother of all qualities, and any man can develop it.
Indeed, he let us play a little game:
“Let’s think for a moment that you have the right to buy 10% of one of your classmates for the rest of his/her life, and you had an hour to think about it. What are you going to do? Are you going to have your friends take an IQ test?”
Warren Buffet doubts it:
“Are you going to pick the one with the best grades?”
He doubts it too.
According to Warren Buffet, you would pick the humble one who gives credit, who is an altruist… In a few words, the one who shows good leadership qualities.
Then, Warren Buffet makes us assume the opposite scenario:
“Imagine you had to go short 10% on someone in your class” (it means you would make money if your friend fails in life).
“Who would you pick? Would you pick the person with the lowest IQ? Or the person with the lowest grades?”
Again, Warren Buffet doubts it.
He believes you would choose the person who turns you off the most; the dishonest person, the one who cuts corners, who does not give credit to others.
In a few words, Warren Buffet’s message is:
“It doesn’t matter how smart you are, what is your IQ score, if you lack leadership skills you won’t be successful in life and therefore, in business.” (check out Six Life and Investing Principles from Warren Buffet)
Why is Buffet’s speech relevant to this conversation?
Buffet was Benjamin Graham’s protégée.
Of the many people who played a significant role in Buffet’s life, Graham is the one who most contributed to his business acumen.
Chapters 8 and 20 of the Intelligent Investor, struck Buffet so much that he followed those principles throughout his life like a religious man would follow the Bible.
Graham and Buffet proposed an alternative view on investing. One that goes against common wisdom for which “you must be super smart to be successful in investing.”
Instead, Graham and Buffet say that you must have another form of intelligence to master investing: Emotional Intelligence.
Who is Benjamin Graham?
Benjamin Graham was born in 1894 in London, although his family soon moved to New York when Graham was a year old.
His father died when Graham was still a kid, and he lived with his mother almost in poverty.
Nonetheless, Graham made it through Columbia, and after a brilliant academic path, he soon joined Wall Street. Graham was so successful that after a few years, he was already running his investment firm.
How did he succeed?
Benjamin Graham became the father of value investing.
Value investing starts from the assumption that Mr. Market (That’s what Graham called the Stock Exchange) is often wrong.
It means that most of the stocks listed there are either undervalued or overvalued.
What sounds like a marginal assertion today was revolutionary at the time.
Indeed, at the beginning of the 20th century, the stock exchange was considered in the same way as the “Oracle of Delphi,” infallible.
And lucky investors were considered “Gods” rather than men.
In such a scenario, the great depression sounded more like a divine punishment of the gods.
Rather than a simple financial crisis that could be handled. Graham’s ability stood in his analytical framework. This framework consists primarily of dissecting companies’ balance sheets to find those who are undervalued.
What makes Graham’s framework so great?
Anyone can follow it. Just one condition, as Warren Buffet says in “Intelligent Investor” (revised edition by Jason Zweig):
“you need the ability to keep emotions from corroding that framework.”
No man is immune to feelings, as reported by Jason Zweig: the same Isaac Newton went broke because he couldn’t keep his emotions in check and got swept by the “irrational exuberance” of the market.
As the story goes, Newton 1720 owned shares in the South Sea Company, the hottest stock in England at the time. Newton sold his stock for an astonishing %100 return.
Now you might think that one of the greatest physicists in human history would stop there and be happy with what he earned. Unfortunately for our hero, this is not how the story ended.
Newton, thrilled by the upward stock trend, jumped in again and bought it at a much higher price, losing $20,000 (more than $ 3 million in today’s money).
Now, you might say:
“If Newton was not successful in investing, why would I?”
Speculator vs. Investor
Before investing even one dime in stock is crucial to understand the difference between speculation and investment.
Indeed, the speculator is the one who invests with a very short-term horizon, trying to predict the erratic future market fluctuations.
Are you so smart to be able to predict how the trend will be in the future? The truth is that statistically, you won’t be able to do that.
The same Graham, who was a market guru, performed just 2.5% above the market return.
Do you think you would be able to do better? If your answer is “yes,” then you are deluding yourself.
Anywhere today, you find people telling you how they got rich quickly through daily trading.
Although some of them got reached through speculation, statistically, the success rate is meager (around 3.5%).
The investor, instead, is the one who has a much longer perspective and looks at the company’s balance sheet to base his decision.
Warren Buffet suggests applying as much due diligence to the stock you buy as you would do when buying something critical.
Think for a second about the time we spend researching the new car to purchase or the new smartphone. Why, when it comes to stock investing, do we approach it almost with the “slot machine player” mindset?
Our brain is not wired to handle money (as it’s a relatively modern invention)
As it turns out, our brains take quite other routes regarding money. Psychologically, our mind has not been wired to handle money.
We struggle so much. Also, it seems like we own nothing when it comes to stock. In particular, today, with the new sophisticated systems, anyone can buy shares with one click.
Before approaching the market, ask:
- Do I understand how this business works?
- Would I keep this stock for my entire life?
- Is the financial position of this company strong enough?
These three simple questions can keep you away from troubles afterward. Speculating is neither right nor wrong but just what it is.
Therefore, if you are classified as a speculator, keep in mind that you are betting against the market in the same way as the guy who bets horses, thus expecting to lose all your money.
If you are an investor, you can set your expectations so that the capital will be safe and you will receive a satisfactory return.
What is an adequate return? Do not expect to become reach in one day, one year, or ten.
According to Graham if you are patient enough, you might get rich since your return will compound.
Also, by reinvesting your dividends, you will have tax advantages.
In conclusion, according to Graham, the speculator tries to anticipate and profit from market fluctuations.
The investor instead looks for “suitable securities at suitable prices.” Are you a speculator or investor?
What advice would Benjamin Graham give you?
Assuming that you want to be an intelligent investor, Graham would tell you:
1. Do not look at market fluctuations.
Instead, focus on understanding the business you are buying.
In one case, only the investor must look with an eagle eye at Mr. Market: “when it is entirely off.”
In a few words, when Mr. Market overvalues a stock that the intelligent investor owns, or if its market value irrationally exceeds its book value, then it is time for the rational investor to sell and benefit from market irrationality.
Conversely, if a stock is extremely underpriced compared to its book value, the intelligent investor will “shop at a discount.”
Why do we wait entire months for “Black Friday” to have discounts on clothes, and when it comes to stock investing, we neglect those “discounts”?
The best deals are found in times of irrationality; the intelligent investor knows that and does not follow the crowd nor buy what is fashionable at the time.
2. Do not waste your time forecasting how the Market will perform in the future.
You might get lucky once and make a lot of money. Although, this will lead to catastrophe.
Why? Well, if you are like the average speculator, after jackpotting from your lucky forecast, you will convince yourself to be a “Market guru” and to have understood how the Market works.
In this moment of ultimate delusion, you will increase the stake, go “all in,” and lose it all.
You are warned the intelligent investor “knows that he knows nothing” about future market movements. If you forget this basic principle, you will be easily deceived and doomed to failure.
3. Do not be fooled by the management.
The intelligent investor knows that good management is as important as analyzing the books.
When valuing his returns, he must apply the same metrics when looking at the management’s performance over the years.
If the “Do Not” catalog is not enough, Graham would give you the list of “Do.”
4. Know what you are doing and know your business.
In a few words, stop spending hours of your day watching business channels and reading the newspaper.
Focus instead on analyzing balance sheets and management of the organizations you want to invest in.
Also, examine them at least with the same degree of due diligence you would use if you had to buy a new car or house.
5. Master your inner game.
Build your emotional strength, and do not listen to the continuous flow of information produced to “make noise.”
“Know thyself,” understand how you feel, and which emotional reactions you have when investing.
Only by studying yourself can you master the world around you. Change your perception of the world, and suddenly the world will seem different.
6. Master your circle of competence.
Focus 100% of your brainpower on things you understand and let the rest go. Warrant Buffet has followed this principle all his life long.
He never put a dime in tech stocks because he could not understand them.
That does not imply tech stocks must always be ignored by your investment. However, ask yourself: do I know how this business works?
Why should I follow Graham’s principles?
Well, there is no particular reason to implement those laws besides everything you tried did not work.
If you are stuck at investing and need a successful system, then there is no hurt in trying those principles.
How to keep emotions from sabotaging our success in investing.
Each time you lose money investing, don’t fool yourself into thinking: “I am a particular case,” “none feels like I do,” and “I have been such a failure all my life, and I will always be.” That is a deception your brain is constructing to make you feel the “victim.”
Biologically speaking, it is true that each human being is different in some way; since our DNA has so many possible arrangements for any person on earth.
On the other hand, though, we are all the same when it comes to psychological processes.
We all follow more or less the same thought patterns, although none will tell you what he is thinking; quite the opposite.
Start understanding your thought patterns when investing and laugh at the voices that try to deceive you. But keep in mind:
MASTER YOUR INNER GAME, EVEN BEFORE YOU INVEST A DIME
- Value Investing Philosophy: Value investing focuses on analyzing a company’s fundamentals to identify those with intrinsic value higher than their market price.
- Warren Buffet’s Influence: Warren Buffet, a successful investor, emphasizes the importance of integrity and leadership qualities for success in both life and business.
- Benjamin Graham – The Father of Value Investing: Benjamin Graham, Buffet’s mentor, revolutionized investing with the belief that the stock market is often wrong, leading to undervalued and overvalued stocks.
- Emotional Intelligence in Investing: Graham and Buffet propose that emotional intelligence is crucial for successful investing, allowing investors to stay rational and avoid emotional decision-making.
- Speculator vs. Investor: Distinguishing between speculators and investors is essential. Speculators try to predict short-term market fluctuations, while investors take a longer perspective, focusing on a company’s balance sheet.
- Graham’s Investment Advice:
- Ignore Market Fluctuations: Focus on understanding the business and buy when Mr. Market overvalues or undervalues a stock.
- Avoid Forecasting: Don’t waste time predicting future market movements; an intelligent investor knows they cannot predict with certainty.
- Evaluate Management: Consider management performance alongside financial analysis.
- Know Your Business: Thoroughly analyze companies you invest in, as you would when making other significant purchases.
- Master Your Emotions: Understand your emotional reactions when investing and develop emotional strength.
- Stay Within Your Circle of Competence: Invest in businesses you understand and avoid areas beyond your expertise.
- Reasons to Follow Graham’s Principles: Graham’s principles can serve as a successful system for investing when other approaches have failed.
- Managing Emotions in Investing: Understanding your thought patterns and emotions when investing is crucial to avoid falling victim to biases and irrational decisions.
Connected Financial Concepts
- Accounting Equation
- Financial Statements In A Nutshell
- Cash Flow Statement In A Nutshell
- How To Read A Balance Sheet Like An Expert
- Income Statement In A Nutshell
- What is a Moat?
- Gross Margin In A Nutshell
- Profit Margin In A Nutshell
Main Free Guides: