Value Investing: Long Term Investments with a Margin of Safety

Normally the typical Value Investor takes advantage of the reduction in difference between the share price and actual value of the company, in other words investing with Graham’s margin of safety.

Value Investing is interpreted in many different ways. It is typically understood as purchasing shares in companies that measure favourably against a valuation index.  For others, Value Investing has more to do with the balance sheet of a company than with its profit and loss statement. Others concentrate on companies which obtain higher returns from capital invested.

In his 1992 Berkshire Hathaway shareholders’ letter, Warren Buffett gave the following explanation, in which Value Investing can be seen simply as the purchase of a share for less than its calculated worth:

We think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase. - Warren Buffett -

Value Investing is based upon on a few simple and logical principles and ideas, which are themselves based upon the principles of healthy business conduct.

According to Benjamin Graham, every company has a real, economic value - the so-called ‘Intrinsic Value’ or ‘Central Value’ which is independent from its stock market price. The Intrinsic Value corresponds to the price which a well-informed businessman would pay for the company as a whole were it to be put on the market.

The market is not always efficient. Value Investors recognise that for the most part, the stock market evaluates the majority of companies fairly and that the share price therefore corresponds pretty accurately to the Intrinsic Value of a company. They counter however, the assertion that the stock market evaluates all companies fairly at all times (the Efficient Market Theory).

Furthermore there are regular periods where strong psychological forces can be observed. The share prices during euphoric times can be pushed way above their Intrinsic Values, and in times of panic and anxiety can be pushed way below.

Value Investors only invest when the share price is significantly below the Intrinsic Value. This, for them, creates a Margin of Safety. The lower the share price - in other words the sale price - lies below the Intrinsic Value, the lower the risk of losing money when investing. Together with the increasing sale price there is the opportunity to obtain an above average yield on investment.

This simple logic forms the heart of Value Investing. When buying a company for its Intrinsic Value, the yield of investment is equal to the long-term added value. If the stock market offers an opportunity to buy a company significantly under its Intrinsic Value, the difference between the sale price and the Intrinsic Value is to be taken into account when considering its added value.

Value Investing demands hard work, extraordinary discipline and a very long-term investment horizon. Value Investing is easy to understand but in fact much harder to put into practice. The most demanding elements are of a personal nature. First and foremost it requires self-discipline, patience and the ability to make sound judgements.

Value Investing principles offer a strong possibility for capital investment with limited risk. The key to success is to avoid frequent transactions as well as the ability to make long-term investment decisions on the basic principles of the business world. The word ‘long-term’ has a different meaning for each individual investor. Value Investing does not work in weeks or months. There can be years of below average growth. Despite the long-term investment horizon, Value Investing requires regular evaluations of the Intrinsic Value of an investment.

Value Investors go against the flow. It is easier to join the general consensus. When value investing, it is however not advisable to follow general opinion, but instead to behave counter-cyclically. Value Investors do not follow their heart when investing in companies nor do they look to other market investors for assurance.

By studying the behaviour and the actions of other investors and speculators, investment opportunities constantly arise for Value Investors. The best time for Value Investors to buy is the moment when there is an overall market fall.

Value Investors invest with a margin of safety which protects them against high losses in times of depressed market prices. Admittedly even Warren Buffett had to accept a significant decline in the market valuations of his Berkshire Hathaway investment holding company in the bear market of 1973/74, during which time the share price more than halved from 85 Dollars to 40 Dollars.