Five key principles of value investing
#1: Price is not value
- The worth of a business is independent of the market price.
- Day-to-Day stock quote - how much the few shareholders who bother to
trade that day deicdie their investment is worth; It is categorically
not the worth of the entire company.
- "Price is what you pay, value is what you get" - Benjamin Graham
- Big Swings in the market <>. big swings in the value.
#2: Mr. Market is a crazy guy
- He’s a very accommodating man who tells you every day what he thinks
your shares are worth while simultaneously offering to buy you out or sell you more shares
on that basis.
- Sometimes you may be happy sell out to him
when he quotes you a crazily high price or happy to buy from him when his price
is foolishly low.
- The rest of the time, you will be wiser to form your own
ideas about the value of your holdings, based on updates from the company about
its operations and financial position.
#3: Every stock has an intrinsic value
- The true value of a business
is known as its ‘intrinsic’ value and is difficult, though not impossible, to ascertain.
- ‘Relative’ value - compare a valuation
ratio for the company
(P/E, P/B, P/S, etc...) with its industry peer group or the market as a
whole. - Something that appears to be relatively cheap on that basic
can still be overvalued in an absolute sense.
- 'Intrinsic'
value - measure a company on its economics, assets and earnings
independently of other factors. To establish intrinsic value, is no a
straightforward work & there are multiple, contradictory ways of
calculating it.
#4: Only buy with a margin of safety
- The difference between the market
price and the intrinsic value
is the margin of safety.
- A margin of safety is achieved when securities are purchased at prices
sufficiently below underlying value to allow for human error, bad luck,
or extreme volatility in a complex, unpredictable and rapidly changing
world. - Seth Klarman
- Opinions are divided
on how large the discount needs
to be to qualify the stock as a potential ‘buy’.
- Graham suggested looking for a margin of safety in
some circumstances of up to 50% but more typically he would look for 33%.
#5: Diversification is the only free lunch
- You shouldn’t put all your eggs in one basket – but in practice, it seems to be extremely difficult to pull off.
- Two Camps
- Warren Buffett's ‘focus portfolio’ camp - you should
put all your eggs in just a few
baskets and watch them like a hawk.
- More ‘quantitative’ value farmers - to ‘harvest’ the value premium from the market.
- Graham recommended owning a portfolio
of 30 bargain stocks to minimize the impact of single
stocks falling into bankruptcy or distress
- Joel Greenblatt recommends a similar level of diversification when following his MagicFormula strategy.
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