Having talked about different investment philosophies in the previous article. Many value investors have heard of Warren Buffett. However, how many have heard of Benjamin Graham? For those who have not heard of that name, he is the father of value investing and mentor to Warren Buffett. He was the one who started the whole concept of deep value investing.
Throughout his time as a finance researcher on Wall Street and professor at Columbia Business School, Graham influenced many great and successful investors like Warren Buffet, Charlie Munger, Walter Schloss, Seth Klarman, and Bill Ackman.
As a deep value investor, he has consistently outperformed the S&P500 benchmark by approximately 2.5% annually, for more than 20 years. This was possible because of his deep value investing philosophy.
Here are three key insights that we will be sharing with you that will prove beneficial in kickstarting your investing journey.
Value Investing defined
So, what exactly is value investing?
As mentioned with an emphasis in his book “The Intelligent Investor”, there are primarily two type of people in the stock market: investors and speculators.
The following quote from the book will give you a better idea of the difference.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
In other words, value investing is an activity that requires hard work, an eye for details and most crucially, prudence. Otherwise, you will just be swept along in the waves and surges of fleeting speculative activities.
Now, one may ask “What does it take to start investing?”.
To be a value investor, one has to take a step further by being conscious of the intrinsic value of the company in question. The intrinsic value of the company is the true economic value of the company at the prevailing market conditions. The decision to invest is dependent on the options available and opportunity costs from investing.
The idea of companies having an intrinsic value is simple and straightforward but the derivation of intrinsic value is half art and half science. Investors who are overly quantitative and complex may potentially fall prey to human errors such as overconfidence. Others who disregard any form of yardstick will have no idea how much their company is truly worth.
Hence, a value investor is one who uses objective judgement to determine the fair value of the company in question after considering qualitative and quantitative factors. Qualitative factors can be micro such as management’s competence, or macro such as its position in the industry capital cycle. Quantitative factors will involve number crunching operations to determine values of assets and possibly cash flow generating ability.
If value investing is such a straightforward concept that works since the beginning of financial markets, why don’t everyone adopt it? We will explore this lingering thought in your minds below.
The market is not always right
Value investing works because of an inherent inefficiency in the financial markets.
Graham believes that pursuing long-term active returns using a deep value investing approach requires a great amount of discipline and emotional intelligence. Such characteristics are uncommon due to human behavioral biasness.
Mr. Market is an imaginary investor who will approach you everyday offering to buy or sell his shares at different prices. While Mr. Market may offer you a reasonable time most of the time, he may also turn up at your door with absurd offers. This is so due to emotions. Feeling euphoric, Mr. Market will quote a sky-high price, while other times, being depressed will urge Mr. Market to give up his shares at rock-bottom prices.
As diligent and rational value investors, we should not be affected by the emotions of Mr. Market. Rather than buying at any prices that Mr. Market offers, we should remain calm and exploit Mr. Market’s emotions and only purchase when he is depressed and selling at rock-bottom prices.
Margin of Safety
While it is extremely tempting to view oneself as right and others, as in Mr. Market, as wrong, one has to constantly remind ourselves that we are also prone to psychological biases.
Graham knew that humans are prone to huge margins of errors. Self-attribution bias is one psychological bias example about how we foolish people think about ourselves. When we manage to earn higher returns, we have the tendency to attribute this to our own skill. On the flipside, when our portfolio suffers, we will choose to blame it on external factors such as bad luck.
To deal with such inherent psychological biases that exist in all of us, Graham proposed an allowance for error, which he termed as the “Margin of Safety”.
The path to picking stocks is littered with numerous psychological and technical loopholes. We have a natural tendency to forecast favorable scenarios, especially if we already have a liking for the company. Since there is great uncertainty in the analysis of companies, it is intelligent for us to be aware of what factors requires us to have greater “margin of safety” than others. For instance, while the typical analyst in the financial markets always pushes the idea of favorable demand growth, sales growth and assets growth, it is more prudent to focus on factors that have greater predictive power such as supply-side factors and current asset values.
“Margin of Safety” is one of Benjamin Graham’s most important and famous phrases. Investors who actively accounts for a margin of safety in investment decisions, will protect themselves from unfavourable and unforeseen events.
Through this article, we hope that investors would be able to gain a better understanding of Graham and his deep value investing philosophy. Along your investing journey, mistakes are bound to be made and your attitude towards such events will determine whether you will be a successful investor or not.