What is Value Investing?
Value investing is the art of investing in businesses at a discount to a conservative estimate of their intrinsic value. That's it! Value investing (all investing really) is an incredibly simple process that can be summed up accurately and completely in one sentence. That does not mean it is easy to carry out in practice. It is a very difficult process that takes discipline and patience.
The fundamental tenet behind value investing is that it is exceedingly difficult to predict the future price of any asset. Some quants can do it well in limited circumstances but even they usually have very specific domains. Momentum investors will tell you that stocks that have performed well recently are likely to perform well in the near future. That is true, until it isn't. Momentum strategies tend to do very well in rising markets and very poorly in falling ones. For a stock price to rise, it needs buyers. For it to rise again after that, it needs more buyers. Eventually, the number of available buyers is not enough to offset the sellers and the asset price falls. So, the key to successful investing for most people is avoiding the game of predicting prices all together. We can't avoid all predicting, but we must limit our predictions to areas where we have a higher likelihood of being correct.
In order to succeed at value investing, we need to be able to estimate the intrinsic value of an asset. The intrinsic value of any asset is the sum of all future expected cash flows discounted back to present day. I can't predict with any degree of certainty what the price of Apple's stock will be at the end of this year (this applies to whatever year you happen to be reading this.) but I am confident that fiscal year 2022 revenue will be between $275 billion and $500 billion. Through these types of high confidence low precision predictions, we can come up with estimates for the future cash flows of the business.
Once we have estimated the cash flows, all that's left is to discount them back to the present. The choice of a discount rate is another key decision. A discount rate can be thought of as a "required rate of return." Meaning it is a benchmark rate any investment idea must beat before being included in the portfolio. I like to use a discount rate of 10%. Many people will say that this is absurdly high given our low interest rate environment. However, I believe that we should not sell ourselves short. Just because the 30-year Treasury bond yields less than 3%, doesn't mean we should be content with investments that earn 3%. I want to earn 10% or higher so I have a high required rate of return.
In the definition above, I said we want to invest in businesses at a discount to a conservative estimate of their intrinsic value. At this point, we have our conservative estimate of intrinsic value, but at what price are we willing to invest? How big of a discount do we need before we are comfortable investing? There is no correct answer here. It depends on how confident you are in your valuation. Some people might think that the conservative estimate of future cash flows and the high discount rate are enough to say we don't need any buffer. Anything below our already low line is going to be at a discount to fair value.
I believe that the most important thing is to avoid making bad investments. When we make a purchase decision, we want to be confident that the price we are paying is less than fair value. That is the only way to be certain of long-term sucess. A good rule of thumb, one that we will be following around here, is to invest in companies that trade at a greater than 10% discount to fair value.
Value investing is simple, but it is hard. It requires patience because most securities will not reach this high hurdle for investment that we have set. Most of the time, securities trade at or above their fair value. It requires discipline because when markets are going up, we all get FOMO if we aren't participating. It's fun to watch the numbers on your statement go up, but it leads to poor decision making most of the time.
Just because an analysis doesn't trigger an immediate buy decision, doesn't mean it was unsuccessful. If we find a business that we like with an overvalued stock, that is a win in and of itself. Patience will allow us to watch the stock price over time, keeping our fair value estimate up to date, and allow us to jump when the market is more in our favor.
I will post more in the coming days about what value investing is and isn't. Most of the posts on here will be about analyzing and valuing specific companies. Occasionally, I may post about an interesting book I read or an educational topic but generally I want to try to keep it on topic. What I won't post are any "7 stocks you must buy today if you want to retire" or "Market Guru who called 2020 market crash says you should buy this" type posts. I want to keep posts thought provoking and the quality high. If you have any companies that you want me to look at, please let me know.
If you're interested and want to learn more about value investing, I highly recommend reading anything by or about Warren Buffett. If you have ever read anything he's written, you've probably guessed that he is a big influence for me. If you want to go even deeper, his teacher Ben Graham literally wrote the book(s) on value investing.