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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


The Superior Math of Value Investing

I believe value investing is the only rational way to invest. It’s two scoops of common sense, a healthy dollop of skepticism and a commitment to ordering off-menu entrees. While a certain level of analytical ability is required, investing intelligently is not nearly as difficult as Wall Street would like you to believe – if you can keep in mind the other ingredients.

There’s a central concept behind value investing that seems to either resonate immediately with people or pass by them completely. The concept is this: a publicly traded company has two values – its ‘intrinsic’ value, and the value the stock market puts on the business.

Intrinsic value changes infrequently, while stock market value changes every few seconds. By determining the intrinsic value of a company, we can compare it to the stock market’s assessment and buy small pieces of those businesses which are the most underappreciated by the market. Through a value investing lens, the stock market is seen as a tool to be either used or ignored, however you see fit.

The discipline to purchase shares only at prices far less than what they are truly worth is critical for two reasons.

First, it protects you from significant and permanent loss. This “margin of safety” concept is unique to value investing.

Second, buying well below intrinsic value presents the potential for substantial appreciation once the market recognizes the company’s true long-term value. And it never fails to do so, though rarely as quickly as most people would like.

Value investing is a simple concept with surprisingly few devotees. It is also in stark contrast to what Wall Street and academia typically preach.

Where’s the proof ? In at least two places.

First is at the very top of Forbes’ 2008 list of the world’s richest people. There you’ll find Warren Buffett, the most famous practitioner of value investing.

There is a simple math proof, too.

Say Corley buys shares in a company for 50% of their intrinsic value. The intrinsic value of the company then grows 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.

Mathematically, two thirds of that return comes from the gap between market price and intrinsic value
closing. Only one third comes from the business value growing.

There are three key points here:

1 – Growth is essential, but its less important than buying at a low price.
2 – Value investing effectively provides leverage with less risk.
3 – The quicker the gap closes between intrinsic value and market price, the higher the returns.

Here’s Warren Buffett on value investing:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the
temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

The above article was originally featured in our first Letter to Investors. To subscribe, email me.