Value investing is all about stock picking. It involves a process that helps investors find and buy stocks that trade significantly below intrinsic value. But what principles do value investors adhere to which help them in this process? There are three key principles value investors believe in.
First, value investors believe that when they buy a stock, they do not buy a piece of paper. They buy a piece of the company. They do not buy as traders, they buy as owners, and as a result they must know a lot about the company, in fact almost as much as the entrepreneur who runs the company.
Since it is humanly impossible to know, in depth, a lot about a large number companies, value investing implies a concentrated portfolio. For example, Warren Buffett's portfolio is mostly concentrated in five stocks.
Most value investors hold portfolios of 20 to 30 stocks. Holding this number of stocks allows them to know a lot about these companies – in depth. Whereas in a (typical non-value) portfolio of 100 to 200 stocks, it is quite unlikely that a portfolio manager will know a lot about all the companies.
Value investors like to focus on their circle of competence. They do not believe as much in diversification touted in modern portfolio theory, which is taught in university finance courses and in the CFA program.
Modern portfolio theory teaches that stock-by-stock analysis is a wasted effort, since diversification will save portfolios. But there is plenty of evidence to indicate that diversification fails in this when you need it the most.
So value investors beg to differ. They believe in due diligence. And in stock-by-stock analysis. It was John Maynard Keynes who first said, "Once you achieve competency, diversification is undesirable." And Mr. Buffett echoes this sentiment.
Second, value investors believe that the stock market moves up or down many times irrespective of fundamentals. In fact, Ben Graham, the father of value investing, used to say that the market behaves like a "manic-depressive" person. Value investors do not follow such market behaviour but instead they take advantage of it. In other words, when everyone is exuberant, value investors are cautious and when everyone panics they look for opportunities.
Of course, this is easier said than done. It is against human nature. Humans like to herd. They like to follow the crowd as they believe the crowd know something. Such behaviour however is bad for one's wealth.
Nobel Prize winner Vernon Smith, in fact, showed in experiments that humans are momentum traders; they try to buy low and sell high – a process that if repeated enough times leads to crashes – and this is true for both novice as well as professional traders.
Value investors have developed the ability and courage to go against the crowd. If one invests based on the consensus, one will never outperform. We must all have a dose of contrarianism in investing. Mr. Buffett echoes this when he says, "Be fearful when others are greedy and greedy when others are fearful."
Value investors do not believe in market efficiency – in the short run. In the long run, they believe markets gravitate toward fundamental value. This is a necessary condition to make money. If, over the long run, prices diverge from fundamental value, buying cheap will not work. Value investors like to buy cheap and wait for the markets to realize fundamental value and make a profit.
Patience is important here as the market may take up to five years many times to realize fundamental value.
Third, value investors always look for a margin of safety. The margin of safety protects an investment's downside. Valuation deals with the future in an uncertain world. Many things can happen that throw off one's valuation, especially things we do not know we do not know. The margin of safety protects us against this.
At the time of Ben Graham, the margin of safety was 50 per cent. That is why Mr. Graham said that a value investor wanted to buy an asset that is worth one dollar for 50 cents. Nowadays, value investors use a 25- to 30-per-cent margin of safety. That is, if intrinsic value is estimated to be $10, value investors, using a 30-per-cent margin of safety, will not start buying until the stock hits $7 or below. When my students asked legendary value investor Walter Schloss, who was our guest a few years ago, what was the most important thing in investing, his response was, "Do not lose money." This is because once you lose money it is difficult to recover. If an investment goes down by 50 per cent it needs to go up by 100 per cent to break even. The margin of safety protects against such losses, as value investors have already taken 30 per cent off the intrinsic value of a stock before investing in it.
So there you have it. You now know the key principles that help value investors outperform.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.