Chapter 1
What is value investing?
If we acknowledge that investing is the intention to seek a required rate of return (RR) relative to risk based on an assessment of value, then all investing is âvalueâ investing. The deployment of capital in the absence of assessment of value is called speculation.
Although the art of speculation is covered by numerous books on stock trading and technical analysis, why is it necessary to use a tautology by including the word âvalueâ in the title of a book on investing? After all, would it not be equally foolish to refer to a car as an âautomobile carâ or an ATM (automatic teller machine) as an âATM machineâ?
That the market sees value investing as different from normal investing implies that the very factor on which investing is based is little understood, and therefore nearly always ignored.
Value assessment does not rely on precision
Warren Buffett once said, âIâd rather be approximately right than precisely wrongâ. Stock valuation is subjective in that it requires a judgement of the sustainability of past profitability, and is therefore far from being an exact science. Like price, value will not increase in neat, even increments year after year, but will vary with the changing fortunes of the business.
The following commentary is typical of analysts who make buy/sell recommendations in the absence of quoting value and the business performance criteria on which they based their recommendation. One firm featured a leading article titled âBe vaguely right, not precisely wrongâ. The reason for this play on Buffettâs words was to justify their recommendations not being accompanied by an indication of value. Their argument that value infers precision and is therefore misleading would seem to nullify their claim to be experts on value investing. If value investing is not about assessment of value, then what is it? Presumably, being âVaguely rightâ means using some other means to vaguely determine whether a stock should be bought or sold at its current price. How such a vague notion can be used to generate precise recommendations was not mentioned.
An assessment of value is determined by making forward assumptions of a businessâs performance based on its historical performance. Depending on the current outlook for the business and its future prospects, the adopted performance criteria (APC) may differ from those that past performance indicates. One also needs to make an assessment of the RR to compensate for many factors, as discussed in chapter 6. The adopted assumptions are then used in the StockVal© formula to calculate the value, the preciseness of which is not as important as being, as Buffett suggests, âapproximately rightâ. As essential as valuation is in determining the margin of safety between value and price, other factors need to be considered when deciding whether a stock should be bought or sold.
The argument that value is misleading because it infers precision is as foolish as suggesting that real-estate valuations are a waste of time because they too imply precision.
A recommendation may be correct, but unless it is accompanied by evidence of value, it can be considered only an unjustified expression of opinion. Warren Buffett says, âWall Street is a place that people drive to in a Rolls Royce to get advice from people who ride to work on the subwayâ.
Eddie Cantor once said, âThey told me to buy this stock for my old age and it worked perfectly. Within six months I felt like an old manâ.
Investing in stocks is not about buying scrip that will go up and down in price, but about investing long term in a sound business that represents good value at its current price.
So-called âValueâ and âgrowthâ stocks
One of the idiosyncrasies of stock market terminology is that it divides stocks into two separate categories: âvalueâ and âgrowthâ. Growth stocks are considered to be those whose low dividend yields are compensated for by high earnings per share (EPS) growth, while value stocks are deemed to have the opposite characteristics.
Letâs consider the foolishness of this notion. A company that distributes all profits as dividends and then replaces the distribution with new capital â either through its dividend reinvestment plan (DRP), placements or rights issues â would have the attributes of both value/yield and growth. Similarly, it would serve no purpose to call an interest-bearing deposit a âyield/value depositâ and then change its designation to a âgrowth depositâ when deciding to leave the interest to accumulate and compound.
Value stocks are considered to have one or more of the following attributes: above-average dividend yields, low price/earnings (P/E) ratios or low price-to-book value differentials. Not on...