Price is what you pay. Value is what you get.
In this simple saying, famed investor Warren Buffett makes the important distinction that price and value are not always the same -- a simple understanding that has arguably served as a true north for the Berkshire Hathaway (NYSE:BRK-B) (NYSE:BRK-A) founder, chairman, and CEO as he amassed his fortune. It's with this understanding of price and value that Buffett has successfully practiced value investing for decades.
What is value investing?
Value investing consists of investing in stocks trading at prices below their intrinsic value. Value investors, therefore, are essentially buying stocks at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their intrinsic value.
To better understand value investing, investors should understand a few related terms:
- Intrinsic value: An estimation of a stock's worth. Importantly, intrinsic value differs from a stock's price in that it represents the per-share value of the underlying business.
- Market price: The price a stock is trading at any given time in the stock market. Value investors hope market price volatility will occasionally drive a stock's market price irrationally below its intrinsic value, thus creating a value investing opportunity.
Benjamin Graham, who mentored Warren Buffett, famously articulated how market price can stray from intrinsic value and create buying opportunities in his book, The Intelligent Investor, by making the market out to be an emotional business partner coming back every day with different prices to buy or sell interest in a company:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
- Margin of safety: The difference between a stock's price and its intrinsic value when a stock is trading below its intrinsic value. Usually expressed as a percentage, the bigger a stock's margin of safety, the better.
In a single chart, this is value investing at its core:
There are different types of value investing
Investors should realize that not all value investing looks the same. The investing style is arguably best understood on a spectrum, with a significant emphasis on value at one end of the spectrum and greater emphasis on growth potential at the other end.
Early in his career, Buffett's investing style leaned toward value. Taking after Graham, Buffett sometimes almost exclusively emphasized the value side of the value investing spectrum for a given investment. Looking for cheap "cigar butt" investments, as Buffett would call them, these stocks offered investors a few last free "puffs." Other times in his early career, Buffett would look for more sustainable operations, but he was more focused on finding a stock trading at $0.50 on the dollar of its immediate value than he was on looking for long-term holdings that could compound over the years.
Later in his career, though, Buffett began to appreciate growth potential. This shift in his value investing philosophy was particularly influenced by his investing partner, Charlie Munger, who Buffett credits for helping him understand it is "far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price."
By buying quality, sustainable businesses with strong competitive advantages, value investors can reduce portfolio turnover and boost their chances of meaningful long-term price appreciation. With this shift in thinking, Buffett began to look for investments Berkshire could essentially hold forever -- holdings like Coca-Cola, Wells Fargo, and American Express, which Berkshire has owned for decades and still owns today.
One key benefit to shifting his emphasis from buying cheap stocks to prioritizing businesses with exceptional economics and competitive advantages is that Buffett no longer needed to be as concerned with when a stock should be sold. Buffett summed up this thinking in a 1998 Berkshire Hathaway shareholder letter:
In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.
Overall, there's no hard-and-fast rule for exactly what value investing is. However, probably the most central theme between different forms of value investing is that they all are anchored by value. Even Buffett's evolved approach to value investing, for instance, aims to buy wonderful businesses at fair prices -- not overvalued prices. As soon as investors begin ignoring intrinsic value altogether, they are no longer practicing value investing.
Given how well value investing with a focus on companies with sustainable competitive advantages has consistently worked out for Warren Buffett, and considering this approach's perk of low portfolio turnover, investors may be wise to follow in Buffett's footsteps.
Daniel Sparks has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool owns shares of Wells Fargo. The Motley Fool recommends American Express and Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.