In the beginning there was the idea of investment – straightforward, unconstrained investment – whose goal was to maximize long-term after-tax returns…PERIOD
It was a simpler, happier time, when the essence of investment was to seek out value; to buy what was cheap with a margin of safety. Investors could go from bonds to stocks as they saw fit. If prices were too high, then value investors held cash.
Modern Finance Theory was born.
Then in the 1950s, a young researcher at the RAND Corporation was figuring out how much of his retirement money to allocate to stocks and how much to bonds. An expert in linear programming, Harry M. Markowitz, described his solution in a scholarly article called “Portfolio Selection” for the Journal of Finance purportedly showing exactly how to calculate the tradeoff between risk and return in portfolio construction. Modern Finance Theory was born.
It’s clear that after the financial panic of 2008, investing needed to get back to its roots in the garden of Value Investing. The best place to start is in the beginning with Ben Graham – the founding father of Value Investing.
He said, “Investment is most prudent when it is most businesslike.”
Unfortunately, most investors give more attention to stock market price swings than to what the underlying businesses are doing.
Value Investing Approach
The value investing approach looks for investments at sensible prices and holds that it is wise to think first about the business and its industry.
It views stocks as little pieces of a whole businesses. The goal is to determine whether that business is undervalued, fairly valued, or overvalued, a systematic business-like approach to investing. But in the long-run the market is Weighing machine – where eventually intrinsic value and price converge.
The stock market is merely the place to buy ownership shares in undervalued companies, or to sell shares at fairly valued prices
At the very heart of value investing is the belief that the price paid for an investment drives the likely return. A stock can be a good investment at one price, but not at another.
This approach inherently rejects modern financial theory in which price and value are equal.
‘Price is what you pay, value is what you get.’
As Warren Buffett quotes Ben Graham as saying, ‘Price is what you pay, value is what you get’.
For value investing, in the short term, the stock market is nothing more than a voting machine that determines the prices of shares by popular vote every minute of every trading day. These prices change much more than the values of the underlying businesses do.
Also, value investors define RISK much differently than the academics and modern finance adherents. They define risk, “using the dictionary which says risk is the possibility of loss or injury’.” Owners of businesses define risk the same way, and as owners of shares of those businesses, value investors do too.
Risk in Value Investing
Proponents of Modern Finance Theory define “risk” much differently than value investing. For them, risk is the relative volatility of a stock or portfolio of stocks, a precise mathematical measure of risk called standard deviation defined (by sigma) or BETA.
These precise measures obscure the real idea of risk — the possibility of losing money.
Therefore, most advisors and investors think the stock market is “risky” where they really mean “volatile”— it goes up and down a lot in the short-term. So, they put too little of their savings in stocks because they cannot bare the pain of watching the value of their savings go up and down in the short-term. Why do they care if they don’t sell?
Value Investing, Margin of Safety, and Safety-First Investing
Value investment like stock market volatility because it is the necessary condition for the higher returns of stocks. Plus, they purchase investments with a margin of safety – a discount to their conservative estimate of intrinsic value.
They know that any estimate of intrinsic value will only prove to be correct due to luck. So they buy only when a large discount to that estimate is available because it offers protection against being wrong.
As Ben Graham taught, the margin of safety is ‘available for absorbing the effect of miscalculations”.
Value investing is ‘safety first’ investing. It places risk management at the very heart of the process
Value Investing is the belief that the price we pay for an investment determines its likely return, and that Price does not equal value.
1. Value investors think of RISK as a Permanent loss of capital, NOT volatility as do the academic finance quants. And,
2. Value investing knows that any estimate of intrinsic value will only prove to be correct due to luck.
3. Therefore, buying only when a large discount to that estimate, or a margin of safety, is available, offers protection against being wrong.
And that’s it – VALUE INVESTING gets us back to the time when investing was simple – straightforward and unconstrained – when the goal was to maximize long-term after-tax returns…PERIOD.