There are many ways to make money in the stock market. The most commonly cited approaches are value investing, growth investing, and day trading. There are many arguments for and against each of these investing styles, but value investing is probably the most reliable one for making money in the stock market over the long haul.
What is value investing?
In its most basic form, value investing consists of buying stocks at a discount to an estimation of intrinsic value in hopes that the market will eventually recognize the underlying worth of the business. What is intrinsic value? It's simply an estimate of a company's true worth.
In one chart, value investing may look something like this:
While most value investors agree that the approach constitutes buying a stock only when it trades at a discount to fair value, offering a margin of safety, there is less consensus among value investors on when to sell. Not only does selling have tax implications, but it can also mean selling the best-performing company in a portfolio -- not necessarily the best performer as a stock, but the best performer as a business.
So some value investors opt for alternatives to simply selling stocks as soon as they become overvalued. These alternatives are usually to sell a stock only if 1) it appears grossly overvalued or 2) the underlying business fails to meet or exceed expectations.
What is the history of value investing?
Benjamin Graham was the mentor to the world's greatest investor, Warren Buffett. And Graham is often referred to as the father of value investing.
While Graham certainly didn't popularize the term value investing, he did identify the core principles of the philosophy -- particularly the idea of a margin of safety and intrinsic value.
Buffett, now among the world's richest men, added an important criterion to value investing that begins to blur the lines between value investing and growth investing. Investments, Buffett says, should have an economic moat -- that is, a durable competitive advantage. That factor is probably the most recent major evolution in this approach to investing.
"In business, I look for economic castles protected by unbreachable moats," Buffett has said. The wider the moat, he argues, the more sustainable the business.
But the more sustainable the business, the more investors will need to rely on future estimations of cash flow. And once value investors begin attributing a significant portion of an asset's value to future potential, investors will start to lean toward a growth investing approach.
Perhaps this is why Buffett concluded in his 1992 annual letter to Berkshire Hathaway shareholders that "the two approaches are joined at the hip."
How many value investing approaches are there?
Value investing is best viewed on a spectrum, with conservatism at one end and growth at the other. While both ends of the spectrum require businesses to have an economic moat, ones at the growth end require investors to rely heavily on growth projections. And ones at the conservative end aren't growing quickly and often make estimating intrinsic value an easier task.
There are value investors who prefer slower-growing businesses with a substantial track record, so that they can feel comfortable about their estimation of intrinsic value (and hopefully reduce risk), and there are value investors who go for faster-growing companies and closely observe the qualitative factors that could preserve higher growth rates. Both are value investors, just on different ends of the spectrum.
What is the advantage of value investing?
These are the most significant advantages to value investing:
- Portfolio turnover is low (and, thus, portfolio maintenance is low).
- Having a margin of safety means investors can win even when they were too aggressive in their fair-value estimate.
- Investors don't have to watch the market very often, since intrinsic value estimations aren't going to change very often.
As with most forms of investing, it's important to remember that it is an art, not a science; there are no hard-and-fast rules to value investing.
But if you decide value investing is for you, keep these three concepts in mind. Margin of safety, intrinsic value, and economic moat are the pillars of the value investing approach.
Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.