Wednesday, 27 March 2013

Graham’s basic principles of value investing

Value investing

Value investing is a much used phrase and means, in general terms, buying something for less than it is worth. It can apply to just about anything. You can value invest in shares, in bonds, in property, in postage stamps, in vintage cars. The difficulty is in calculating the value of the thing in which you are investing. In many things (postage stamps, collectible cars etc), the only way that value can be determined at any given time is the price that someone is prepared to pay for the item at at that time. The investor in that asset is, as a result, subject to the opinion of others.

Benjamin Graham proposed a method of calculating the value of a stock and Warren Buffett has both applied and enhanced Graham’s approach.

Benjamin Graham: the ‘father of value investing’

It was Benjamin Graham who applied to the theory of investing the concept ofintrinsic value. According to Graham, if you can determine the intrinsic value of a share, then you can ascribe to that share a real value that is not dependent upon the opinion of others (the whims of Mr Market). If you can then buy that share at a price less than its intrinsic value, giving yourself a satisfactory margin of safety, you have made a prudent and rational investment. An investor who holds a diverse portfolio of stocks acquired by this process should, over time, finish ahead.

Benjamin Graham did not apply the term value investment to this investment approach; that has been done by others. He did however called this intelligent investing, indeed the only real form of investing. Buying shares on the basis of value is investing. Buying shares on other bases such as the belief that the market will rise generally, or that a particular industry is good, or that others will bid the price up, is not investment but speculation.

Graham’s basic principles of value investing

In The Intelligent Investor, Graham sets out his strategies for making investments based on value for various types of investor – passive and active, defensive and enterprising – but each approach rests on these basic principles:
  • When you buy a stock, you are buying a share in a business.
  • The market price of a stock is only an opinion of the value of the stock and does not necessarily reflect the real value of that stock.
  • The future value of a stock is a reflection of its current price.
  • An investor must always build a margin of safety into the decision to buy a stock.
  • Intelligent investing requires a detached and long term approach, based on careful research and reason, and not on the opinions of others or the prospects of short term gains.

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