Island Investing: The Math of Value Investing

Q. Why do you say value investing is the best way to pick stocks?

A. I believe value investing is the only rational way to invest. Some analytical ability is required, but investing intelligently is not nearly as difficult as Wall Street would like you to believe.

There’s a central concept behind value investing that people seem to get immediately or it eludes them forever. The concept is that a publicly-traded company has two values – its actual or ‘intrinsic’ value, and the value the stock market assigns to it.

Intrinsic value changes infrequently, while stock market value can change every few seconds. By determining the intrinsic value of a company, and comparing it to the stock market’s assessment, we can buy small pieces of the best businesses which are the most underappreciated.

Purchasing shares only at prices far less than what they are truly worth is critical for two reasons. First, it protects you from 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 rarely fails to do so.

Where is the proof that value investing works? In at least two places.

First is at the very top of the 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. So growth is essential when looking for companies to invest in, but it’s less important than buying shares at a low price.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
This entry was posted in Island Investing and tagged . Bookmark the permalink.