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.
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.
Indeed, when Buffet was still young and inexperienced, he found in Graham’s books “Intelligent Investor” and “Security Analysis” the foundation of his business success.
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.
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.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
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
Successful Historical Examples of Value Investing
1. Berkshire Hathaway – Warren Buffett
Overview: Warren Buffett, often hailed as one of the greatest investors of all time, built his fortune through value investing principles imparted by his mentor, Benjamin Graham. Buffett’s conglomerate, Berkshire Hathaway, has investments in various industries, including insurance, utilities, and consumer goods.
Value Investing Strategy: Buffett adheres to Graham’s philosophy of focusing on a company’s intrinsic value rather than short-term market fluctuations. He seeks undervalued companies with strong fundamentals, durable competitive advantages, and trustworthy management teams.
Outcome: Berkshire Hathaway’s long-term success and impressive returns demonstrate the effectiveness of Buffett’s value investing approach. Investments in companies like Coca-Cola, American Express, and Wells Fargo have yielded substantial returns over decades, showcasing the power of patient, disciplined investing.
2. The Washington Post Company – Benjamin Graham
Overview: Benjamin Graham, known as the father of value investing, applied his principles to his investments in The Washington Post Company. Graham acquired shares of the media conglomerate when it was undervalued, recognizing its solid financial position and market potential.
Value Investing Strategy: Graham’s investment in The Washington Post Company exemplifies his focus on analyzing a company’s financials and identifying undervalued assets. He saw potential in the company’s diverse holdings, including newspapers, television stations, and educational services.
Outcome: Graham’s investment in The Washington Post Company proved lucrative as the company’s value appreciated significantly over time. The media giant’s expansion into new markets and successful business strategies validated Graham’s belief in the importance of thorough analysis and patient investing.
3. McDonald’s Corporation – Value Investing Principles
Overview: McDonald’s Corporation, a global fast-food chain, has been a consistent performer in the stock market, attracting value investors due to its strong brand, predictable cash flows, and global presence.
Value Investing Strategy: Value investors recognize McDonald’s as a stable, dividend-paying company with enduring competitive advantages, such as its recognizable brand, efficient operations, and extensive franchise network. These factors align with Graham’s emphasis on investing in companies with strong fundamentals and competitive moats.
Outcome: Investors who applied value investing principles to McDonald’s stock have benefited from steady returns and dividend income over the years. The company’s ability to weather economic downturns and adapt to changing consumer preferences underscores the resilience of businesses with enduring value.
4. Johnson & Johnson – Long-Term Value Creation
Overview: Johnson & Johnson, a multinational healthcare corporation, has been a favorite among value investors for its diversified portfolio of consumer healthcare, pharmaceuticals, and medical devices.
Value Investing Strategy: Value investors appreciate Johnson & Johnson’s consistent earnings growth, robust balance sheet, and commitment to innovation and quality. These factors align with Buffett’s and Graham’s emphasis on investing in companies with enduring competitive advantages and shareholder-friendly management.
Outcome: Investors who recognized Johnson & Johnson’s intrinsic value and long-term growth potential have been rewarded with capital appreciation and dividend income. The company’s ability to deliver value to shareholders while maintaining its leadership position in the healthcare industry exemplifies the success of a value-driven approach to investing.
5. The Coca-Cola Company – Warren Buffett’s Iconic Investment
Overview: Warren Buffett’s investment in The Coca-Cola Company is legendary in the world of value investing. Buffett recognized the enduring strength of Coca-Cola’s brand, global distribution network, and consistent cash flows.
Value Investing Strategy: Buffett’s investment in Coca-Cola exemplifies his focus on investing in companies with durable competitive advantages and long-term growth potential. Coca-Cola’s iconic brand, extensive distribution channels, and loyal customer base align with Buffett’s criteria for value-driven investments.
Outcome: Buffett’s investment in Coca-Cola has been highly lucrative, with significant capital appreciation and dividend income over the years. The company’s ability to generate consistent returns and adapt to changing consumer preferences underscores the resilience of businesses with enduring value.
Key Highlights
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.
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.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
