Finance academics define risk as volatility, whereas value investors see risk as the probability that adverse outcomes in the future will permanently impair the business’s potential cash flow and investor’s capital. Which is correct? It all depends on your investment horizon. But if maximising terminal wealth is of importance to investors, and it is difficult to argue otherwise, then value investors have it right.
Let me explain.
There are two types of fundamental analysts: short-term and long-term. Short-term fundamental analysts are the typical financial analysts. They accept the stock price as given and try to determine what will make the stock price move. Their price targets and investment calls are affected by the release of short-term economic or corporate news. They react to such announcements.
Value investors are long-term fundamental analysts. They do not react to short-term announcements. For example, the short-term noise of whether the next quarter’s earnings deviate from expectations is immaterial. What is material for value investors is whether the company continues to have strong fundamentals, be well managed and financially sound, as well as “cheap.” The stock price is not important; instead, it is the difference between the intrinsic value and the stock price that is important. If the stock price is significantly below the intrinsic value (by a predetermined margin of safety), then the stock is considered cheap, and value investors buy. Otherwise, they wait.
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So what exactly is this value investing that led Warren Buffett to be so rich?
In Value Investing, you are essentially buying stocks — which essentially is a part ownership in a business — that is worth $1 for 50 cents (this is just an analogy). There are many reasons why you can buy a stock that is worth $1 for 50 cents.
One of the reason is that many stock investors do not understand what they are buying or selling — they simply buy and sell stocks based on hot tips or based on chart patterns.
That forces them (at times) to sell a good stock at a cheap price.
In which, the practitioners of value investing will take advantage of that by buying the stock they sold.
“Value investing in fundamentally different from stocks trading.While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price relative to the business value. This is done by first determining the rough intrinsic value of the business.” – Chris Lee Susanto
Value investing works because simply put, the stock market is not efficient.
That means that the stock market at points in time does not accurately reflect the true value of the business behind the stock.
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Mention value investing and the phrase brings up different connotations for different people.
Some investors see value as a style as a dead regime, something stuffy old investors like Warren Buffett (Trades, Portfolio) live by, and their devout following of the strategy has cost them big time as they have missed out on some of the market’s best opportunities.
On the other hand, you have the devout value investors, those who remain fully committed to the strategy initially set out by Benjamin Graham and his partner David Dodd, all those years ago, even though this strategy has generated relatively lackluster returns over the past decade.
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