If you are an active investor, sooner or later you will come across the concept of value investing.
Value investing is a style of investing that has changed significantly over the past 80 years. It was first defined by Benjamin Graham, who is now widely known as the Godfather of value investing.
When he went on to teach investing at Columbia Business School, Graham inspired a generation of investors including Warren Buffett, who has built a fortune of more than $80 billion with Graham’s ideas.
A strategy built on fundamentals
When Benjamin Graham first developed value investing, the financial world was very different from what it is today. Most so-called investors were just speculators; they only cared about stock prices and dividends. It was virtually unheard of to evaluate a company’s shares on financials and metrics such as the price to earnings ratio.
The problem was, for the first few decades of the 1900s (and for many years before) it was relatively difficult to get hold of financial information. This, as Graham found out, presented a tremendous opportunity for those investors who were willing to go the extra mile.
Graham was willing to put in the extra work. He developed a strategy based on finding stocks trading below the value of the assets on their balance sheet. He believed investing in these companies was virtually risk-free because if they liquidated, investors would still receive more than they paid for the company as the assets were sold off.
Graham invented this strategy and Warren Buffett refined it. In the 1950s and 60s, Buffett turned a $100,000 into a $100 million fortune by investing in so-called net-net stocks, companies with a market capitalisation below the value of net current assets.
The changing face of value investing
Over the years, as technology has improved, value investing has changed. Today, anyone has access to company financial information at the click of a button, and as a result, it is now virtually impossible to find high-quality stocks trading at a discount to net asset value.
That said, while the rest of the world has changed, the principles underpinning value investing haven’t. Graham taught his students the importance of fundamental business analysis and the critical distinction that stocks are not just lottery tickets, they are in fact a piece of business and should be treated as such. And even though net net or deep value investing is difficult today, valuation remains as important as ever.
A core principle value investing is the margin of safety. Put simply, this is the difference between the intrinsic value of a stock and its market price. The wider the margin, the more scope there is for profit. This margin also protects against any unforeseen developments, which could derail your original investment thesis. The cheaper a stock becomes, the wider its margin of safety. The more expensive it is the less room there is for manoeuvre if things don’t go to plan.
Value investing has changed since it was first invented, but the margin of safety principle remains highly relevant today. As investors, there is not much we can control in the market, but we can control when we buy and at what price. By using these value investing principles, we can tilt the odds of investing success in our favour.