We often refer to value investing strategy, when we discuss Buffett’s trading style.
Buffett’s investment strategies have a distinct Ben Graham touch.
Not only Ben Graham was his mentor, but also the guiding force.
It is considered the key to the massive wealth he built.
However, the question that comes to the fore is what exactly this investment philosophy is?
What is the value investing concept that it champions?
More importantly, is it the secret mantra for all of Buffett’s market understanding?
Well, it is imperative to understand what is value investing first.
Only then, can you grasp the entire concept in totality.
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What Is the ‘Value Investing Strategy’?
The term value investing essentially means investing in value.
It is a strategy where you select stocks which are trading below their fair value.
Essentially traders look for undervalued counters and buy them at bargain levels.
Investors target profiting from the irrationally undervalued levels.
The whole idea is that investors behave irrationally to both losses and gains.
This strategy helps them to capitalize on this irrationality and profit from it.
So, if the valuations don’t match the stock fundamentals, this becomes an opportunity to buy for them.
If the fundamentals of the stock support, the price can rise substantially.
Investors carefully seek counters that have less than average price-to-book ratio.
This is one of the best indicators of fair value.
When a stock is trading below the average price to book ratio, it is an undervalued counter.
However, there is a fundamental problem with this concept.
The concept of value in value investing strategy can be quite subjective.
I might be assigning a value on the basis of select parameters.
But you might be using completely different ones.
As a result, the value that I assign will be significantly different from what you do.
This is exactly why the concept of ‘margin of safety’ is important.
Somehow, it tends to assign a certain degree of rationality into the core concept.
Some investors look at present assets to assign value.
While on the one hand, you have others who look at future growth prospects.
But the ‘margin of safety’ ensures that you always have some room for error.
This will help you change your investment and undertake course correction.
That alone can yield sustainable value for the longer term.
Warren Buffett’s Trading Philosophy
In this context, it is important to understand that Buffett championed this concept.
But he was not the proponent of this value investing strategy.
Buffett essentially followed the Graham school of investing.
Therefore, value investors are like bargain hunters.
They look for undervalued counters and weave their trading strategies around them.
The idea is to garner as much profit as possible.
But this theory also includes a certain amount of market hypothesis.
This is a point of concern for many seasoned investors.
But Warren Buffett has taken it to new levels.
He looks at value purely from the long-term concept.
The Oracle of Omaha is never quite satisfied with profit in terms of capital gained.
He looks at the bigger picture, the concept of value appreciation over time.
He, therefore, concentrates on extracting value in companies that can generate income.
Yes, the potential to generate income is one of Buffett’s biggest benchmarks for value.
Buffett never plunges into his value picks in a hurry.
He always considers the intrinsic value carefully.
The overall consistency of performance is also an important consideration.
So, when Buffet chooses his value buys, he does not look at them as stocks.
He invests in them as companies.
The moment this difference comes to the fore, you see many other differences.
Most importantly, you are able to focus on those elements that matter the most.
You start evaluating the stock on the basis of its performance.
Past assets or future projections alone could cloud the overall projections.
In comparison, the performance parameters give a more realistic perspective.
It explains exactly what the company is capable of and how the stock benefits.
The market Buffett maintains will always acknowledge this worth eventually.
This is exactly where this strategy gains.
Graham’s Three Pillars of Value Investing
Benjamin Graham’s book, The Intelligent Investor, transformed Buffett’s career for good.
He read this book as an enthusiastic teenager in 1949.
Graham wrote this book in 1928.
It was a guide about a unique approach to trading, value investing.
Graham was developing this along with his fellow professor, David Dodd, at Columbia Business School.
This book was essentially about stocks that traded below fair value.
The book highlights how this kind of trading shields against sudden market changes.
For Buffett, this trading approach was a game changer of sorts.
He was so influenced that he eventually joined the Colombia Business School in 1951.
He took Graham’s classes first hand.
This became the foundation of the trading theory that he went on to follow.
The major highlights of Graham’s teaching comprised of three cardinal points.
- A stock value is directly based on the value of the company or the business.
- A wide margin of safety is an absolute necessity.
- Don’t give in to market swings; use it to your advantage.
Essentially Graham’s value investing strategy was all about identifying value.
He stresses the need to maintain calm and deal with eventualities coolly.
Do You Own the Stock or the Business?
This is perhaps the most important concept.
As Buffett often says, you can easily get overwhelmed by stock movement.
While dealing with it, you tend to forget a shareholder owns a small piece of the business.
So in many ways, the stock indicates your ownership.
It is an indicator of your long-term interest in the business fundamentals.
So eventually, the stock is only as expensive or valuable as the business.
As a trader, therefore, it becomes important to adapt your mindset.
You need to be ready to pay for the business and not just stocks.
This is perhaps the cardinal point in the value investing strategy.
I am sure that you have often noticed that Buffett buys for the long-term.
He also becomes closely involved in the business of the company.
Be it the best practices in place or corporate governance; he leaves his distinct mark.
It is hard to ignore Buffett’s influence.
Maintaining the Margin of Safety
This is the next most important aspect of the value investing strategy.
As the name indicates, Buffett highlights the need to create the safety net.
As Ben Graham proposed, you are after all dealing with stocks trading below fair value.
There can be unexpected swings in the market.
The safety net acts as a protective covering against these eventualities.
It provides investors better prospects to recover if the trade goes wrong.
After all, let’s face it; you won’t always get the trade right.
An adequate margin of safety means if you have at least some ground to recover losses.
After all, determining the true value of any company is tricky business.
Even determining value on the basis of earnings projection is not simple.
There are many factors that influence earnings.
A wide safety margin also ensures a wider profit perspective.
So, if your trade goes right and the stock rises to fair value, you get better profits.
In many ways, your rewards for the right become better.
Side by side you don’t get penalized as much for the wrong call.
Don’t Get Swayed by the Market
I am sure you have read or heard about this in Buffett’s every speech and column on markets.
This is the third and most important lesson from Graham’s value investing theory.
It highlights the need to keep markets at bay.
Graham uses the term, ‘Mr. Market’ to personify a moody and unpredictable character.
He repeatedly stresses the need to keep markets at bay and not get trapped.
Value investing strategy is about how well you can use the market forces.
At no point in time, should you yield to its forces?
This means instead of you following the markets; you need to set the trend.
Graham mentions considering the market as a business partner.
Buffett goes a step further and considers it as an irrational partner.
The result, now and then, you might have unpredictable swings.
Buffett repeatedly mentions that you should not panic at such times.
You must always look to buy low and sell high.
Therefore, it is also an important lesson in maintaining your calm.
It is about restraining yourself amidst wide-spread hysteria.
Whether you are dealing with a panic selloff or euphoria, it is never simple.
Restraint helps you remain within the safety net and not go overboard.
The idea is to make these wild swings work to your advantage.
Panic and excitement lead to losses.
Restraint and cool strategizing can help in booking profit.
The choice, therefore, is yours.
If you follow the grand old man of Wall Street and his mentor Graham, it is all about playing it cool.
Value a Long-Term Proposition
There is another interesting point in Buffett’s value investing strategy.
Buffett also stresses on looking for intrinsic value and sound business fundamentals.
But he never insists on selling a stock on high.
If you go by the Berkshire investment policies, most of their holdings are long-term.
This highlights one of the most striking aspects of this investment philosophy.
It also looks at creating value by holding the stock for long.
There are many instances where Buffett selling a stock has triggered a further selloff.
The consensus has been that if Buffet has sold a stock, perhaps there is value erosion.
Buffett maintains that value counts, sooner or later.
The market might remain delinked from the value for an extended period, but that is temporary.
Eventually, the value parameters do play catch-up in the wider perspective.
Many have, however, questioned the veracity of this strategy in modern markets.
But historical data from Wall Street do not quite support those claims.
Every time markets have questioned this; there have been periods of value-investing highs.
Buffet has never mentioned the need to sell once stocks get above fair value.
Perhaps this is the most defining element of the overall value play.
Benefits of Value Investing
This is exactly why we can debate the pros and cons of this investment strategy.
So what are the obvious advantages of this value investing strategy?
1. Anyone Can Invest
This is one of the most important factors.
Almost anyone can invest in the market.
For value investing you do not need fancy stocks or huge cash.
You can even look for value in smaller counters.
Investing the right amount of time and patience is crucial. That is what will help you get the best returns.
2. Easy Profits
Well, trading in stock markets is never simple. But the advantage of this strategy is it gives you a fair chance.
If you can select stocks with strong business fundamentals, you can get reasonable returns.
If the fundamentals of a stock are good, they will bounce back at some point in time.
This means you can remain confident about returns sooner or later.
Moreover, the primary value investing plays are less susceptible to short-term dips.
This makes this kind of stock more resilient to market forces.
3. Low Volatility
This is undeniably one of the biggest advantages.
When a stock is trading below its fair value, there are fewer chances of huge or volatile moves.
Moreover, you are buying the stock for the longer period. So, there is significantly lesser chance of dealing with intra-day volatility.
You don’t need to monitor your stock on a minute by minute basis.
By that extension, it also reduces the relative risk profile in your portfolio.
Also, you don’t have to deal with timing challenges in this case.
You are after all playing for the longer term.
So, you don’t have to time the market in the shorter term.
Demerits of Value Investing
But there are some disadvantages of this kind of investment strategy as well.
1. No Immediate Gains
You need to have an investor mindset.
Think about how Buffett and Graham look at it.
You cannot look for instantaneous gains.
The gains will be spread out over a point of time.
Moreover, you can’t panic in case of short-term dips either. You need to stay focused on your long-term goals.
You have to keep your vision set at the business fundamentals and how they lend value.
2. Patience Is Virtue
This is one situation where you need a lot of patience.
Estimating value for a specific stock can be extremely time-consuming.
It can sometimes take years for the stock to attain value. So, you have to really give up expectations of instant returns.
You need to remain focused and convinced about this strategy.
On a day to day basis, there is hardly any change in the stock value.
Value only emerges on a long-term basis.
3. Assigning Value Is Difficult
This is the cardinal challenge of value investing strategy.
How do you ascertain the right value for a stock?
Some experts would designate a value to a stock based on assets.
However, there are many who would derive it from future projections.
This is a very subjective matter and can always be counted as the biggest demerit.
You need to have a strong understanding of the financials. Only then you can properly analyze the stock’s fundamentals.
Also, this gives you the necessary depth to interpret earnings and future projections.
Value Investing Strategy Is All About Execution
Therefore, we can conclude that the value investing strategy is all about execution.
Ben Graham devised it, and Warren Buffett made it a hero.
But if you want to profit from it, you need to do significant hard work.
Investing in markets is never simple, more so if you play in the long-term.
Moreover, this is one of those investment styles that contrast extremes.
You have to contend with sudden dips and long-term profits.
You need to believe in fundamentals and stay away from distractions.
But at the end, like most other investments, your judgment is primary.
Never be in a hurry to pick stocks for value investing.
Remember the tortoise’s tale.
The slow and steady win the race.
Undertake thorough research and make a comprehensive study.
That alone will give you the power to be convinced about the choices you make.
You have to be 100% sure about your picks to extract gains from value investing strategy.