value-investing

What Is Value Investing? Value Investing In A Nutshell

Value investing is a strategy advocating the purchase of stocks that are underappreciated by other investors or the broader market. Value investing was popularised by investor Warren Buffett, but the approach was pioneered by Benjamin Graham and David Dodd at Columbia Business School in the early 1920s. Graham would later go on to release the seminal book The Intelligent Investor in 1949.

Understanding value investing

Buffett himself became a student of Graham’s and was later employed by him at the investment firm Graham-Newman Corporation. In one of his many interviews, Buffett had this to say about value investing: “The basic ideas of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.

Value investing is based on the central premise that every stock has an intrinsic value. Investors can analyze a company’s fundamentals and then purchase stock if they believe it is undervalued. Over time, most stocks realize their intrinsic value and the value investor makes a profit in the process.

The four pillars of value investing

Benjamin Graham suggests four components explain the somewhat philosophical approach behind value investing.

These pillars are:

Mr. Market

The value investor should imagine they are in a business relationship with Mr. Market, who offers higher prices when in an optimistic mood and lower prices when in a pessimistic mood. The time to purchase value stocks is when Mr. Market is in a pessimistic mood.

Intrinsic value

We touched on intrinsic value earlier, which Graham defined as the “true” value of a company based on its financials. However, it’s important to note that modern value investors also consider qualitative factors such as industry dynamics, competition, and consumer behavior.

Margin of safety

The margin of safety gives value investors a buffer if their value estimations are overly optimistic. To that end, Graham suggested investors “buy stocks the way you buy groceries, not perfume”. Investors must know the difference between price and value and purchase stocks that are on sale, so to speak.

Investment horizon

Value investing is a long-term strategy and is not concerned with what a stock price is doing in 3 days or 3 months from the time of purchase. Instead, it seeks to identify stocks that will outperform the market over a horizon measured in years.

Other notable value investors

It would be remiss of us not to mention some of the other well-known proponents of value investing. The approach has served as inspiration for such investors as:

Charlie Munger

The long-time business partner and friend of Buffett who some consider to be his right-hand man. Munger is still value investing at the age of 98 and recently noted in an interview with the Australian Financial Review that “I’m still looking for more value than I pay for.

Joel Greenblatt

An American hedge fund manager, investor, and writer who also taught MBA students at Columbia University’s Graduate School of Business. Greenblatt is the author of the value investing book The Little Book That Still Beats the Market.

Mohnish Pabrai

An Indian-American businessman, philanthropist, and author. Pabrai is a self-confessed Buffet-imitator and once paid more than $650,000 to have lunch with the man. His firm Pabrai Investment Funds managed $636.8 million in assets according to an April 2021 SEC report.

Key takeaways:

  • Value investing is a strategy advocating the purchase of stocks that are underappreciated by other investors or the broader market.
  • According to Benjamin Graham, value investing has four pillars: Mr. Market, intrinsic value, a margin of safety, and a long-term investment horizon.
  • Some of the most notable value investors include Charlie Munger, Joel Greenblatt, and Mohnish Pabrai. 

Main Free Guides:

Connected Business Concepts to Value Investing

Circle of Competence

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.

What is a Moat

moat
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.

Buffet Indicator

buffet-indicator
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.

Warren Buffet Companies

warren-buffett-companies
Warren Buffett is an American investor, business tycoon, and philanthropist. Known as the “Oracle of Omaha”, Buffett is best known for his strict adherence to value investing and frugality despite his immense wealth. He is among the wealthiest people in the world. Most of his wealth is tied up in Berkshire-Hathaway and its 65 subsidiaries.

Connected Financial Concepts to Value Investing

Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

price-ceiling
A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

price-elasticity
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

network-effects
network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Creative Destruction

creative-destruction
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

happiness-economics
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Command Economy

command-economy
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Animal Spirits

animal-spirits
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

state-capitalism
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

boom-and-bust-cycle
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
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