In my last column, I suggested ways to tap the wisdom of the best value investors around. Beginning with today's column, I'd like to provide some basic tenets of value investing, which should prove especially helpful to the novice investor and serve as a refresher for the veterans out there. Specifically, I want to shed some light on what differentiates "value" investing from the other approaches and behaviors exhibited by stock market participants.
The source code
My three favorite sources for clear and elegant treatment of the art of value investing are Benjamin Graham's classic The Intelligent Investor, the compiled wisdom of Berkshire Hathaway
I. Be an Investor, not a Speculator
II. Don't Lose Money
III. Learn to Value Businesses
IV. Know Your Circle of Competence
V. Demand a Margin of Safety
VI. Wait for the Perfect Pitch
VII. Make the Market Your Servant, Not Your Master
VIII. Invest for Absolute, not Relative, Returns
IX. Watch the Business, not the Stock
X. Know When to Sell
All investing is value investing
While the term "value investing" means different things to different people, as Buffett notes in the 1992 Berkshire annual report, the term "value investing" is redundant: "What is investing if not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value -- in the hope that it can be sold at a still higher price -- should be labeled speculation (which is neither illegal, immoral nor -- in our view -- financially fattening.)"
That said, permit me to expound on the first three commandments; I'll cover the other seven in subsequent columns.
I. Be an Investor, Not a Speculator
The first rule of value investing is to make the conscious choice to be an investor, not a speculator. I can think of no other reason why Graham would have devoted chapter one of The Intelligent Investor to the topic of "Investment Versus Speculation" other than that this distinction is core to the practice of value investing.
In Margin of Safety, Klarman contrasts the philosophical difference of an investor versus that of a speculator.
To investors, stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk. Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Investors in a stock thus expect to profit in at least three possible ways: from free cash flow generated by the business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in multiple that investors are willing to pay for the business as reflected by a higher share price; or by a narrowing of the gap between share price and underlying business value.
Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others.
I'd hasten to add that there is nothing wrong with speculating per se, and even Graham concedes that the willingness of somebody to assume speculative risks is necessary and beneficial to the market place. Graham wrote that "there is intelligent speculation as there is intelligent investing." It is important, however, to know the difference. Speculating when you think you're investing is a good way to lose your money.
II. Don't Lose Money
Warren Buffett is fond of saying that the first rule of investing is "Don't lose money" and the second rule is "Never forget the first rule." Seth Klarman offered the following interpretation in Margin of Safety:
This does not mean that investors should never incur the risk of any loss at all. Rather, "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal. Avoidance of loss is the easiest way to ensure a profitable outcome.
What Buffett is referring to when he talks about losing money is permanent capital loss. Successful value investors learn to avoid investments that could result in substantial permanent capital loss by ensuring that they are getting at least a dollar's worth of value for every dollar invested.
On the other hand, value investors willingly incur the risk of "quotational" loss. Buying a cheap stock for 60% of a conservative appraisal of true intrinsic business value doesn't guarantee that the stock can't fall to 50% or 40% of intrinsic value. However, as long as the business value does not deteriorate (and presuming that the appraisal of intrinsic value was not fundamentally flawed), such losses will be regained in time as the gap between price and value inevitably narrow.
III. Learn to Value Businesses
The key skill set in value investing is that of estimating the true value of a business. It is also the hardest to learn, and it takes many years of trial and error to refine the skill. Because any value estimate of a business requires the necessity of estimating the likely cash flow profitability of a business, such estimates are by their nature imprecise. Further, there is a substantial margin for error inherent in predicting the future performance of even very stable and reliable businesses, such that any estimate of the value of a business is best expressed as a range rather than a single per-share number that can lead to a false sense of precision.
There are many good sources of information on how to go about valuing a business, but each investor ultimately develops his or her own feel for the process. Every purchase of a stock should be driven by the conviction that the stock is selling for less than it is worth to a rational purchaser of the entire business, a conviction produced by confidence in one's ability to value the business in question.
In my next column, I'll cover the topics of circle of competence, margin of safety, waiting for the right pitch, and taking advantage of the market rather than being guided by it.
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Guest columnist Zeke Ashton has been a longtime contributor to The Motley Fool and is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. Please send your feedback to [email protected]. The Motley Fool is investors writing for investors.
