The idea of value investing is credited to Benjamin Graham in his 1934 book “Security Analysis.” In the book Graham spoke of two essential qualities: The degree of safety of principal, and a satisfactory rate of return. In his margin of safety principle, which Warren Buffett later adopted, Graham noted that there should be a sufficient difference between the price of a stock and the intrinsic value of a company. A buying opportunity would be when the price is at least lower by two-thirds of the intrinsic value of the company to provide a sufficient safety cushion. The intrinsic value is obtained by multiplying the estimated earnings of a company by an appropriate capitalization factor then adding the net real assets of the company.The quantitative aspect of valuation was further developed by John Burr Williams who defined it as the discounted present value of a company’s future cash flow. Joel Stern took this concept as the basis of the discounted cash flow approach in the 1970s, and later the economic value added valuation in the 1990s. As for the qualitative aspect of valuation, it was Philip Fisher who added an essential element, namely that in order to obtain above-average return, investors should focus on a few companies with above-average potential, and capable management.
Warren Buffett, an astute student of Graham, best exemplifies the practical aspects of value investing. Between 1965-2010, he has succeeded on averaging an annual compounded rate of return of over 20 percent, while the S&P 500 index had just over nine percent during the same period. Buffett’s achievement rests on simple rules, and depends not on third party reports or complex models, but rather on analysis he carries out himself.
There are three main tenets of investments for Buffett. Firstly, the business should be simple, understandable, have professional management, and must be a consumer-monopoly business (i.e. a company with a well-known brand, unique product and loyal customer base). Secondly the company should offer high return-on-equity, specific profit margins, and other financial ratios. Thirdly, the value of a company should be sufficiently higher than the price paid for it. Buffett also looks for low-debt companies, and companies that need little in capital expenditure. Growth would come through reinvested earnings, which would reflect on growth of the company. Typical Buffett companies on which he made significant gains include Coca Cola, H&R Block, Gillette, and Wells Fargo.
As a value investor you are simply a screener for value in companies with particular features such as the tenets used by Buffett. You do not forecast company earnings, or any economic events, since—as history keeps reminding us—we cannot forecast anything with sufficient accuracy. Rather, the focus would be on buying a monopolistic company at a discount price to its intrinsic value.
Value investing can also be applied to whole markets, the ones Alan Greenspan referred to as the “irrational exuberance” in 1996 – in other words, markets which overrun their intrinsic valuation. Looking back at the Fed’s July 1997 Monetary Policy Report gives us indications of their model of valuation: They compare the ratio of earnings yield (the inverse of the market P/E ratio) to the ten-year Treasury Bond Yield. If the earnings yield is lower than the ten-year Treasury Bond yield, then the market is overvalued.
Finally, you should keep in mind that the two key elements of value investing are long–term thinking, and consistency. Long-term means over five years, and it is based on the notion that a value company bought at a significant discount reaches its intrinsic value over time. It can also involve buying during a crisis such as war or recession. Buffett made some of his gains from buying during recessions, such as his purchase of the Allstate insurance company during a recession in the industry.
The second element is consistency, which you achieve through discipline. Buffett created his wealth not by chasing hot stocks, but by averaging a 20 percent return consistently through disciplined investing over 35 years. Value investing is simple but not easy to implement due to the fact that we have a natural preference for short term gratification, and patience is difficult in facing an economic downturn, or an underperformance for a year or two. Moreover, loss aversion, over-confidence, and herd mentalities are also behavioral impediments to our application of value investing.