Value investing is an investment style
developed in 1928 by Benjamin Graham and David Dodd at Columbia
University. It is based on the purchase
of shares at a discount on their intrinsic value (perception/estimation of
their real value), taking advantage of short-term stock market fluctuations to
invest in the long term, since market prices do not always represent the
fundamentals (quantitative and
qualitative information) of long-term companies.
1. The term "value investing" is often used incorrectly.
Many people consider that it
refers to the purchase of shares with characteristics such as a low PER
(price-to-earnings ratio of companies) or a high dividend yield. These characteristics do not determine
whether an investor is obtaining more value than the price he is paying.
Warren Buffett, probably the best investor in
history, quotes John Burr Williams in his book The Theory of Investment Value:
“The value of any stock, bond or business today is determined by the expected
inflows and outflows of money during the rest of the life of the asset and
discounted at the appropriate interest rate ”(Williams, 1938). In other words: The value of the company must
reflect the amount of money it will generate in the future.
Important concepts.
2. Investment and Speculation
According to Graham, what differentiates an
investor from a speculator is their attitude towards market movements. The speculator will try to profit from market
fluctuations, while the investor will want to buy and hold appropriate stocks
at good prices.
It could be delved a little deeper, as Warren
Buffett did when he stated that the investor intends to obtain returns on the
asset, using capital now to obtain more capital in the future through the
operations of the asset itself. The
speculator focuses on the movements of the shares.
3. Safety margin
Difference between the intrinsic value and the
value indicated by the market. The
secret to a sensible investment, according to Benjamin Graham, is the margin of
safety. A safety margin is important to
reduce the negative effect of calculation errors.
4. Pricing and Timing
We can take advantage of the fluctuations of
the actions in two ways: “timing” and “pricing”.
Pricing: It is about buying shares or keeping
them when the price is below their intrinsic value and selling them when the
price rises above that level.
Timing: It is about trying to predict the future direction of the market. This is achieved by buying or holding when the market is going to be bullish and selling when the market is going to be bearish.
The smart investor can obtain very good
results through pricing.
However, Graham believes that
investors can never believe the predictions
about the future direction of
the market.
Investors and businessmen should not stop
buying a wonderful business because of short-term concerns about the economy.
30 years ago, no one could have anticipated
the great expansion of the Vietnam War, price and wage controls, two oil
crises, the resignation of a president, the dissolution of the Soviet Union, a
508-point drop in the Dow in the same day, or interest on treasury bills
fluctuating between 2.8% and 17.4% (Buffett, 1994).
6. Book value and intrinsic value
They are two different concepts. The book value is the net equity of the
company as it appears on the balance sheet.
It is an economic concept, which takes into account the economic
contribution of the capital that has been contributed and of the retained
earnings.
The intrinsic value is the estimate of the
money that the company will generate in the future discounted to the
present. It is the intrinsic value per
share that matters.
Therefore, the book value indicates what has
been put into the company and the intrinsic value indicates what can be taken
from the company.
Two companies with the same
capital contribution can have very different valuations.
7. Efficient Market Theory
The efficient market theory says that all
information about companies is already reflected in stock prices, so analyzing
companies is useless.
Therefore, a person selecting
actions at random would have the same probability of success as the most
hard-working stock analyst.
It is a great advantage for value investors to
have competitors who have been taught that companies are not worth analyzing.
8. Mr. Mercado
Stocks on the stock exchange are very liquid,
that is, investors can buy or sell the shares at the market price whenever they
want as if a man named Mr. Mercado offered to buy and sell shares at a certain
price.
Therefore, investors can know
the market value of their positions at all times.
On certain occasions, Mr. Mercado's ratings
are reasonable but are usually either too high or too low. A smart investor will be happy to buy when
the price is low and to sell when the price is high.
Stock prices are determined by the supply and
demand of investors and this makes it sometimes possible to buy business shares
at prices much lower than those that would have been achieved through private
purchase.
Inflation
Inflation is the increase in the general level
of prices of goods and services.
In 1949, when Benjamin Graham published The
Intelligent Investor, in the United States they were well aware that they had
to face inflation due to the decrease in the purchasing power of the dollar in
the past and the fear of sharp falls in the future.
Stocks have certain advantages over bonds
since they offer some degree of protection in the event of currency
depreciation. bonds do not offer that
protection, (since the interest they offer is not adjusted for inflation).
If an inflationary spiral ever occurs, stocks
are the best place to maintain your purchasing power. Germany in the twenties and Argentina after
its strong devaluation in 2002 are good examples of this phenomenon, the stock
market rose sharply during that period in both countries. This makes sense since companies can increase
prices when there is inflation. Cash
depreciates and fixed income, the value of which is fixed in nominal terms,
also loses value.
9. Austrian School of Economics
According to this theory, the fractional
reserve banking system continuously generates economic crises. This is because, in periods of credit
expansion, banks generate new liquidity that is invested without there having
been any prior savings on the part of the population (granting more loans based
on deposits).
The interest rate becomes lower than it would
have been without a credit expansion, which in turn leads to new investments in
capital intensive projects.
Entrepreneurs start new investment projects as if society had increased
their savings.
However, a large number of these bank-financed
projects end up not being profitable, which is why many companies fail, and
this seriously affects banks.
In periods of monetary expansion, the money
supply grows through a bank multiplier, but this artificial expansion ends in
an inevitable contraction caused by the increase in defaults and by the return
of loans that generate a reduction in the money supply. This is accompanied by a decrease in the
value of the assets of the banking system.
Several investors have commented that they
managed to avoid investing in certain sectors before the 2008 financial crisis
thanks to this economic theory.
As we see, the Austrian school
considers that business cycles are caused by bad investments made when the
interest rate is artificially kept low.
For more details, we recommend reading the
book Money, bank credit, and economic cycles.
Regardless of our political and economic ideology, the book is extremely
helpful in understanding how the current banking system works. Furthermore, it
explains it in a surprisingly simple way, starting with the history of banking
crises.
Thank you.
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