Value investing, as we have noted before in articles such as Beyond belief, is a broad church and its fundamental principles offer enough scope for its ‘congregation’ to adopt a variety of approaches. One of the best illustrations of this is the way value’s most famous living exponent, Warren Buffett, was able to explain his shift across the aisle – from what we have characterised before as ‘deep value’ to ‘quality value’.
Buffett had been a student of Ben Graham – the author of value’s founding text The Intelligent Investor and thus the patron saint, so to speak, of the former style. As his Berkshire Hathaway investment company attracted ever greater amounts of money, however, Buffett was forced to change his investment approach – and then reconcile it to his investors.
Responding to a question posed at Berkshire Hathaway’s annual shareholder meeting in 1995, Buffett argued the metrics used to value a business were secondary to the key messages Graham sets out in The Intelligent Investor. Wherever you see yourself sitting in the value church, then, it is well worth reminding yourself what the Sage of Omaha saw as the discipline’s key tenets.
Think in terms of ‘Mr Market’
In Chapter 8 of his book, on the attitude investors should adopt to the stockmarket, Graham introduces us to ‘Mr Market, noting: “Every day Mr Market tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell to you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.
“Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.” Approaching the market in this way and using its gyrations to your advantage would, Buffett argued, leave you ahead of 99% of other investors.
Build in a margin of safety
There are so many things to be wrong about when valuing a business, it surely makes sense to have some sort of buffer in place in case some of the assumptions turn out to be wrong. After all, as Buffett has argued, if you were driving a lorry weighing 9,800lbs, you would feel pretty comfortable driving across a high bridge built to carry 30,000lb vehicles – rather less so if the bridge was only built to carry 10,000lb ones.
In a similar vein, investors ought to be looking at companies trading at large discounts to their underlying value – and then have the patience to allow Mr Market catch up with their view of that value. Moreover, here on The Value Perspective, we believe – and the academic evidence supports the view – that life becomes a good deal more straightforward if that value is screaming at you in the face.
Remember stocks are businesses
In the course of valuing a company, furthermore, never lose sight of the basic truth that you will be buying a share of a business – not simply a piece of paper that goes up and down in value. That mindset should leave you approaching investing in a very different way than if you were purchasing a share for short-term appreciation or because someone had told you it was a ‘hot’ stock.
On the face of it, these three principles may seem straightforward enough but the execution is far from that – hence another Buffett maxim: “Investing is simple but not easy.” However you approach it, value investing not only requires sound analytical skills to pick out the good opportunities from the bad, it also requires discipline, resilience and patience to ensure that initial hard work comes to fruition.