What is Value Investment
This post will deal with the central question of all. What is Value investment?
In fact, let’s take a step back and first ask “What is Investment”
In case of stocks, definition of Investment is “Buying a stock with the expectation of stock price appreciation, dividends or some combination of them”
But then what is Value Investment. Is it anything different? Anybody who buys anything from an investment point of view; be it real estate, commodity or a stock is hoping that he has paid lesser price than the current or future value of it and this will cause the price to increase in future.
If the person has not done enough analysis and has not pondered enough about the price he is paying versus the worth he is getting, he is just gambling or speculating. He is not doing any type of Investing, forget Value Investing.
So in a way, Value Investment is a redundant term and shouldn’t even exist. All Intelligent Investing is Value Investing.
Now that we have got this out of the way, let’s discuss what are different types of Investing/Value Investing. Primarily, there are two shades of it. Let us name them after people who popularized it.
Graham and Dodd Style
Benjamin Graham and David Dodd pioneered this concept and it focuses on finding beaten down stocks. Let’s assume that there is a stock whose Current Intrinsic Value is 100. However for some reason, its stock price is a lot lesser than 100. There could be many reasons for this mismatch. Whole market is down, the sector is down, company is having tough but solvable problems, and market is incorrectly concerned about the company’s future and so on.
Please note, this method does not try to find fantastic companies. It tries to find decent companies available at fantastic prices. It is called “Cigar Butt” method nowadays.
The biggest risk associated with this method is the Value Trap. We often think that company is decent and is available at discount. But what if it is available at discount because it is junk? If a stock goes down 90% and it is available for a low P/E, it doesn’t necessarily make it cheap. If the company’s earnings are on a steady decline and in a year or two there will be no earnings, a low PE doesn’t mean much. What if the earnings are there only on paper? People love to try and catch a falling knife but this usually results in bloodied hands. Turnaround stocks seldom turn around. This is why a thorough, detailed research is very important to ensure that the price of stock has fallen disproportionately and not because it deserves the fall.
Buffett and Munger Style
Warren Buffett’s methods used to be very similar to Benjamin Graham. However, now Warren Buffet and Charlie Munger’s methods have evolved, to some extent because of the huge portfolio they have to handle. Their aim is to buy a fantastic company even if it means paying a higher price for it. If the Current Intrinsic Value of the company is say 100 but the Future Intrinsic Value of the company is going to be 500 in say 10 years, it is still a very profitable deal. If you pay 150 or even 200 instead of 100 for this company, you will still make a handsome profit.
The biggest risk associated with this method is the Price Trap. No matter how good a company is, there is still a price beyond which it is not worth it. In year 2000, Infosys adjusted to Splits and Bonuses was at about Rs 800. Now it is at about Rs 2000. So it has barely increased by 2.5 times in 15 years. Even a Fixed Deposit would have given about 4 times. And it is not like Infosys hasn’t grown. It has grown 60 times in terms of sales and 40 times in terms of profit. Yet stock hasn’t done well, simply because stock price was too high in year 2000. And then there is always a possibility of a black swan event. In 2005, no one had expected Orkut to stop being the market leader in 2-3 years and shut down within 5 years after that. 23 companies out of original 30 Sensex companies, the bluest of blue chips are no longer a part of Sensex. The fact is everything in the world will die one day. This includes companies too and the end is often sudden. So it is fine to pay more for a great company but beware of getting carried away and pay too much.
So which approach is better
This is fairly like asking which is better: Trying to hit sixes or taking singles. Sixes have higher potential return but are riskier. Singles are safer but obviously potential returns are lower. It also depends on what are you better at. It is safe to say Graham and Dodd style historically has given higher average return but at the cost of higher standard deviation. Part 2 of this post will discuss the pros and cons of both approaches.
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