Two Cornerstones of Value Investing

Because of Ben Graham and his successful disciples, namely Berkshire Hathaway's (NYSE: BRK-A  ) Warren Buffett, the essential concepts of value investing are well known: margin of safety, intrinsic value, and so forth. In my research, I have discerned two distinct approaches that practitioners of value investing seem to obsess over.

Value investors understand risk
Market price fluctuations do not equal risk. Too often, there's a misconception that a stock's price volatility is the same as the stock's risk. This often leads to very expensive mistakes. A business would not pose any more risk on, for example, Oct. 19, 1987, when the market fell about 23% -- just as a business without recurring revenues or profits would be less risky because of an accelerating stock price during the tech bubble.

Much to the chagrin of my finance professors, beta is not a measure of risk but a measure of volatility. Buffett provided a brilliant question to the advocates of modern portfolio theory about Washington Post (NYSE: WPO  ) in 1973. At the time, the Post could have fetched some $400 million in a fire sale and was selling for a fraction of that price. Would a further price decline in the market value of the Post, implying a higher beta, suggest that it is now riskier to buy $400 million worth of assets for an even lower price?

And the idea that greater returns come only from taking on additional risk makes no sense to a value investor. In fact, the exact opposite is true. Risk is the probability of a permanent loss of capital, and one of the core concepts of investing -- the margin of safety -- asserts that greater returns come from assuming less risk. The partners of value firm Tweedy Browne suggest:

One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk.

Value investors are obsessed with preserving capital
Loss avoidance is the cornerstone of every value investor's philosophy. Buffett's rule No. 1 of investing is "Never lose money," and his rule No. 2 is "Never forget rule No. 1."

Avoiding losses is based on a sound mathematical reason: The effects of compounding on even moderate returns over a number of years are mind-boggling. Consider the effects of $1,000 compounded in the following table:

Rate

10 Years

20 Years

30 Years

8%

$2,159

$4,661  

$10,063                                                                  

10%

$2,594

$6,727

$17,449                                                                  

16%

$4,411

$19,461

$85,850

Over time, the slightest amounts of change are vastly amplified with compounding, and significant losses destroy the mathematical advantages of compounding. Consider that someone who earns 16% a year for 10 years will have more money than someone who manages to compound money for 20% for nine years and loses 15% in the 10th year!

In the late 1990s, the so-called Internet funds were generating returns as high 90% to 100% per year buying businesses like Amazon (Nasdaq: AMZN  ) and Yahoo! (Nasdaq: YHOO  ) at triple-digit P/E ratios. Today, these funds -- or whatever remains of them -- struggle to boast five-year returns above the market average. The price you pay for a business determines the level of risk you take. Price is what you pay, and value is what you get.

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