Value Investing: What Made Warren Buffett the Second Richest Person in America
Many novice investors have heard the term “value investing,” but few could explain what it entails. This proven approach to wealth creation is responsible for generating vast fortunes while limiting investors’ downside risk.
While more aggressive investment strategies have sometimes produced faster results, this inherently conservative approach to wealth building offers what is arguably the safest strategy. If your goal is to steadily accumulate wealth while limiting your exposure to risk, value investing could just be the strategy you’ve been looking for.
The father of value investing was Benjamin Graham, who wrote the two books where the value investing theory is based upon: Security Analysis (with David Dodd) and The Intelligent Investor.
Graham’s big idea was twofold—investors should buy stocks below their intrinsic value to limit downside risk; and they should recognize that share price has little, if anything, to do with a stock’s intrinsic value.
Graham taught famed investor Warren Buffett at Columbia University, and Buffett credits Graham’s techniques for inspiring his own investment strategy over the past several decades. In 2015, Buffett ranked number-two on the Forbes 400 list of America’s richest people, with an estimated net worth of $62 billion.
Getting Started with Five Principles
Here’s a pleasant surprise: unlike some overly complex trading strategies, value investing is actually quite straightforward. All it requires is some common sense, investment capital, patience, and a willingness to perform your due diligence (mostly reading and accounting).
To help you on your way, here are the five principles you’ll need to uphold in order to become a successful value investor:
1. All companies have a fundamental value.
This should seem obvious, but few investors get it. Apart from a stock’s market price, a company has an intrinsic or fundamental value. So, if you know what it’s truly worth, you’ll know when its current market price is overinflated or undervalued. Then, it’s just a question of identifying high quality companies whose shares are temporarily undervalued in the marketplace.
Think of it as a chance to buy a number of great companies on sale. Just buy them and hold on to them until their share prices more closely reflect their true value. It may take doing some homework on your part, but if you’re willing to put in the effort to find these undiscovered gems, you can buy great stocks at discounted prices that other investors are clueless about.
2. Maintain a margin of safety.
Obviously, if you can buy a great company at a wonderful price, you’ll be in a better position to profit when the time comes to sell it. But there’s another factor at play here called the margin of safety. By focusing your energies on finding the right stock at a great price, you’re limiting your chances of losing money if the stock fails to perform as hoped.
Since you bought the company based on its solid fundamentals when shares were trading at a discount, it’s less likely that the stock will drop significantly because any risk has already been factored into the share price by the marketplace.
Benjamin Graham, for example, would only buy stocks when they were priced at two-thirds or less of their intrinsic value. He felt this margin of safety was necessary to earn the best returns and limit his downside risk.
3. Markets are not necessarily efficient.
The Efficient-Market Hypothesis states that share prices already reflect all available information about a company but value investors don’t buy it. Instead, they believe share prices fluctuate widely; sometimes trading too high, sometimes too low—sometimes right where they should be.
For example, a stock’s price might tumble because a war breaks out or the economy is performing poorly. Other times, a stock may be way overvalued based on hype and speculation. Either way, the share price is not reflecting the stock’s intrinsic value. Being able to recognize—and capitalize—on these discrepancies is fundamental to value investing.
4. Make your own investment decisions.
On Wall Street, the teeming masses of individual investors are commonly referred to as “the thundering herd.” That’s because most people would rather take comfort in buying and selling what everyone around them is buying and selling than invest the time and energy required to figure out what’s going on. If you want to accumulate wealth, don’t follow the herd. Ever.
That’s one of the reasons value investors often take a contrarian approach to the marketplace, selling when the herd is buying and buying when the herd is selling. As Warren Buffett famously said, “Be fearful when others are greedy and greedy only when others are fearful.”
Most importantly, keep your focus on companies that provide consumers with valuable products and services. These are the companies most likely to recover from setbacks. Make your buying and selling decisions based on what the financial statements tell you, not what others are doing. It’s all about intrinsic value in relation to market price.
5. Do your homework and be patient.
Value investing demands due diligence, a long-term mindset, and patience. Sometimes, it can take years for a good investment to pay off. Other times, you may have to wait on the sidelines until shares of that excellent company you’ve been dying to buy finally start trading at bargain basement prices.
Learning to sit on your hands until the right opportunity presents itself is one of the toughest lessons for novices to learn, but it’s essential to becoming a successful value investor.
There are many, many ways to invest. Some offer the thrills of fast money—and occasionally even deliver as promised—but very few of those approaches are sustainable over time.
When it comes to steadily growing wealth while minimizing your downside risk, few approaches offer the consistency and reliability of value investing. You may occasionally lose money—as Buffett has—but you’ll most likely fare better than if you adopted a more aggressive strategy.
Look for the right companies trading at the right price and be disciplined when buying and selling. Above all, remember what Buffett said, “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
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