Funny that you may ask. Oh wait! You didn’t. But I’m going to tell you anyway, or at least I’ll try. Let’s start with a basic overview and definition to figure out, what the pesky term “value investing” really means and what uncle Buffett does.
The term investing is quite clear in my opinion and most people have an idea, what it means. Usually it’s something in sense of “I buy or put $1 into X and I want more than $1 from X later”. Even though it wouldn’t stand as an academic definition, it’s quite accurate. Your “X” could be many things- founding your own company, stocks, bonds, even art. For now, our concern are stocks and stock investing (since that’s what this blog’s about). Here is some room for misconceptions, so let’s clear that out real quick.
When you say “stocks/stock investing” out loud in a room full of people from fields other than stock investing, 9/10 conjure up images of Jordan Belfort from The Wolf of Wall Street or the famous NYSE “trading pit” in their heads. First of all, Mr. Belfort was a broker, the one who intermediates trades between market participants. Secondly, “the pit” is full of day traders, i.e. people who buy and sell shares and make money on the price differences during day. Although it fits the bill for the definition above, it is not investing in it’s true sense. That might seem arbitrary or even arrogant, but in my (and Warren Buffett’s opinion) investing is something else.
I won’t go into history of public companies issuing shares (even though I would like to), but the basic principle is that the companies issue and sell shares by which the buyer of the share gets a partial stake in the company. Then the company uses the money it got from selling their stock to run its business, grow, make profit and return the money to shareholders. Quite simple, right? It is and that’s what “stock investing” is- providing capital for companies which return you more capital.
“Alright alright Dan, I know this, I’m not stupid” you might be thinking. Fair enough, just hang on a second. So what’s value investing then? Well, here is where it gets tricky. Value investing has been traditionally defined as “buying companies, whose intrinsic value is above its current market price by a substantial margin, while having low P/E and P/B multiples, low debt, relatively high profit margin and moderate growth rates”. I highlighted the word “traditionally”, because this approach is quite old and a little out of fashion. This is what “the father” of value investing Benjamin Graham, mentor of Warren Buffett did. While it’s not a bad approach, it doesn’t work that well in current conditions and more importantly, Warren Buffett amended this approach to be more flexible and well suited for years to come.
You might often read or hear “growth investing” juxtaposed as the exact opposite to value investing. It’s been defined as “buying companies, whose most of value, profits and free cash-flows lies in the future, while having P/E multiples above 30 and very high growth rates of at least 20%”. You might often even read an article like “What is better? Value or growth investing?”. I find that question irrelevant for various reasons.
First of all, value and growth investing aren’t two camps where one is black and the other is white. Investing is a spectrum, which of course, has its extremes- on the value end you might find so called “deep value” investors who look almost solely on the accounting books, finding very cheap stocks with big cash reserves. On the growth end, you might find investors who buy tiny or small cap companies which are largely indebted, make no profit but grow like crazy each year. These investors would buy any company, for any price, as long as it grows. But then there is everything in the middle.
Modern value investing
To illustrate what I mean, let’s talk about Peter Lynch. He’s one of the most famous and most successful investors of all time and is often regarded as a growth investor. While he certainly did concentrate on smaller companies which were about to grow fast, he certainly wasn’t buying them just because they grew. If you read his book “One up on Wall Street”, he described his principles for stock picking- high growth rates relative to P/E, strong balance sheet and well managed debt, simple business model with some competitive advantage and strong cash-flows.
Now that is almost exactly what Warren Buffett, the protagonist of modern value investing preaches, except for that Warren focuses on bigger, more stable and more predictable companies. For that reason, even though Peter Lynch focused on small companies which grew, I wouldn’t hesitate calling him a “value-growth investor”. Even Warren Buffett himself said, that growth is always component of value, therefore he wants to see satisfactory growth rates in companies he buys.
Now we are finally getting the idea what modern value investing is, as I call it. Warren Buffett described his approach as “buying excellent companies for a good price” and once again, it’s exactly right. He even warned from buying good companies for excellent price, which often lures incautious investors into bad deals. Now the question is what exactly constitutes an “excellent company” and “good price”. I’ll go more in depth about each in the next article, but for now we could define value investing as buying companies with:
• Strong balance sheet (accounting, yuck)
• Low debt
• High profit margin
• Moderate to high growth rates
• Conservative P/E ratios
• Strong competitive advantage, for example known brand
• Ideally market leaders
• Areas to grow, untapped markets
• Relatively simple business model
• Predictable development
Now it might seem a little complicated, but don’t worry. I will go over each of the criteria and explain, what it is and why it’s important together with examples from the real world. For now, let’s remember that value investing is buying financially strong companies making a lot of money, leading their market, having a strong brand or other advantage with more potential for years to come available to be bought for a good price.
I always think about value investing as buying a Mercedes Benz. For me, it has a lot of value because its reliable, looks great, is luxurious and is extremely comfortable. However, if the price is $100,000, it’s a little too much for me. But if they had a substantial seasonal discount, let’s say 50%, then you are getting something very valuable for a lot less than you normally would. And that is the goal with value investing as well.
That’s all from me now, see you next article. Stay tuned, stay vigilant.