What is “value investing”?
Value Investing became most famous from the book Security Analysis, and is an investing technique that was developed and applied by Benjamin Graham and David Dodd originally. Among the many other successful investors who applied these fundamental concepts are Warren Buffett, Charlie Munger, Charles Brandes, and William Ruane.
Value investing is essentially the application of fundamental analysis (think the fundamentals of the company) to evaluate the appropriate value of a company, and in doing so, to invest in the ones which provide the investor with an immediate value upon their investment. The immediate value referred to comes from companies that maintain a fundamentally strong business but trade at discounts to their book value or earnings.
Does this really Make Sense?
Conceptually it is counterintuitive to invest in companies that have become unpopular or have encountered periods of disrupted earnings, however, it can be said that these companies involve the least amount of risk. As companies become the new “Hot Stock,” high volume associated with mere speculation makes these companies increasingly overvalued, and leads to a highly unstable stock price. When a bit of unfavorable news surfaces, money is pulled out of these companies at a fast pace and causes the share price to essentially crash. This seems to happen more frequently with companies that are very popular and have a higher proportion of the investing population invested in them.
It is for this reason that value is found where a company is undervalued.
This leads us into the idea of a “Margin of Safety,” which was introduced in Security Analysis and later became a central theme of Warren Buffett’s investments.
The difference between the intrinsic value of a share of a company and its subsequent market price is defined as its “Margin of Safety.” Graham and Dodd illustrate, that even with a thorough analysis there will always be room for error, but by including a buffer, or Margin of Safety, there is room for such misfortune.
Graham gives us reason to believe that by creating a portfolio of companies that meet these criteria, and by allowing a margin for error in these calculations, we should realize satisfying returns in the long-run.