Cale Smith, MBA
August 15, 2009
Q. What exactly is value investing?
A. There are numerous opinions about the best way to invest in stocks. Some people believe it’s impossible to beat the market and buy only index funds. Growth investors are constantly seeking the next hot company. Technicians try to predict the future by reading patterns in charts.
Value investors buy stocks that appear underpriced after extensively reviewing a company’s fundamentals. I believe value investing is also 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 them by completely. The concept is that 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. After determining the intrinsic value of a company, we can compare it to the stock market’s value and buy small pieces of those businesses which are the most underappreciated by the market. To a value investor, the stock market is seen as a tool to be either used or ignored.
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 value. And it rarely fails to do so, though not as quickly as most people would like.
Value investing is a simple concept with surprisingly few followers. It is in stark contrast to what Wall Street and academia usually preach. It’s also how Warren Buffett became the richest man in the world. Stay tuned.