The Principles of Value Investing
1. Thorough analysis
2. Safety of principal
3. Adequate return
To succeed as an investor, you must be able to estimate a business's true worth, or "intrinsic value."
"Bascially, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market."
Graham distilled the secret of sound investing into three words, "margin of safety." Any estimate of intrinsic value is based on numerous assumptions about the future, which are unlikely to be completely accurate.
You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." Warren Buffett said the best advice he ever got from Graham was to think independently.
"Purchase and hold for the long term a concentrated porfolio of outstanding companies with compelling growth prospects that you understand very well."
To uncover the business insights described by Fisher's 15 points, investors must do their research footwork, or "scuttlebutt." You should ask questions of management, competitors, suppliers, customers, and anyone else who might have useful information.
"Go to five companies in the industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprising detailed and accurate picture of all five will emerge."
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above average sales organisation?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labour and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company ahve a management of unquestionable integrity?
1. Don't overstress diversification.
2. Don't follow the crowd.
3. Don't quibble over eighths and quarters.
Great Companies at Reasonable Prices - Warren Buffett
"We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the busines to be one:
- that we can understand;
- with favourable long-term prospects;
- operated by honest and competent people; and
- available at a very attractive price."
To determine value, he estimates the company's future cash flows and discounts them at an appropriate rate. This discounted cash-flow valuation is used by countless investment professionals, so Buffett's approach to valuation is not a competitive advantage.
If Buffett cannot understand a company's business, then it lies beyond his circle of competence, and he won't attempt to value it.
Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong.
Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) by simply avoiding big mistakes.
Even if a business is easy to understand, Buffett won't attempt to value it if its future cash flows are unpredictable. He wants to own simple, stable businesses that possess sustainable competitive advantages. Companies with these characteristics are highly likely to generate materially higher cash flows with the passage of time. Without these characteristics, valuation estimates become very uncertain.
He has written that good managers are unlikely to triumph over a bad business, but given a business with decent economic characteristics - the only type that interests hime - good managers make a significant difference. He looks for individuals who are more passionate about their work than their compensation and who exhibit energy, intelligence, and integrity. That last quality is especially important to thim. He believes that he has never made a good deal with a bad person.
Once Buffetthas decided that he is competent to evaluate a company, that the company has sustainable advantages, and that it is run by commendable managers, then he still has to decide whether or not to buy it. This step is the most crucial part of the process.
The decision process seems simple enough: If the market price is below the discounted cash-flow calculation of fair value, then the security is a candidate for purchase. The available securities that offer the greatest discounts to fair value estimates are the ones to buy.
However, what seems simple in theory is difficult in practice. A company's stock price typically drops when investors shun it because of bad news, so a buyer of cheap securities is constantly swimming against the tide of popular sentiment. Even investments that generate excellent long-term returns can perform poorly for years. In fact, Buffett wrote an article in 1979 explaining that stocks were undervalued, yet the undervaluation only worsened for another three years. Most investors find it difficult to buy when it seems that everyone is selling, and difficult to remain steadfast when returns are poor for several consecutive years.
Although Buffett believes the market is frequently wrong about the fair value of stocks, he doesn't believe himself to be infallible. If he estimates a company's fair value at $80 per share, and the company's stock sells for $77, he will refrain from buying despite the apparent undervaluation. That small discrepancy does not provide an adequate margin of safety, another concept borrowed from Ben Graham. No one can predict cash flows into the distant future with precision, not even for stable businesses with durable competitive advantges. Therefore, any estimate of fair value must include substantial room for error.
Buffett has difficulty finding understandable businesses with sustainable competitive advantages and excellent managers that also sell at discounts to their estimated fair values. Therefore, his investment portfolio has often been concentrated in relatively few companies. This practice is at odds with the Modern Portfolio Theory taught in business schools, but Buffett rejects the idea that diversification is helpful to informed investors. On the contrary, he thinks the addition of an investor's 20th favorite holding is likely to lower returns and increase risk compared with simply adding the same amount of money to the investor's top choices.
You can greatly boost your investment returns if you invest like Buffett. This means
- staying within your circle of competence,
- focusing on companies with wide economic moats,
- paying attention to company valuation and not market prices, and finally,
- requiring a margin of safety before buying.
Lynch's mantra is that average investors have an edge over Wall Street experts. The "Street lag" of large institutions gives average investors many advantages because they can find promising investments largely ahead of the professional investors.
Lynch stated, "If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them." Therefore, individual investors can outperform the experts and the market in general by looking around for investment ideas in their everyday lives.
- First, you should invest only in what you understand.
- Second, you should do your homework and research an investment thoroughly.
- Third, you should focus more on a company's fundamentals and not the market as a whole.
- Last, you should invest only for the long run and discard short-term market gyrations.
Investing in what you know about and understand is at the core of Lynch's stock-picking approach. This particular investment principle served Lynch very well in practice.
Company Characteristics that Might Attract Lynch:
- It is boring.
- The industry is not growing.
- The business is specialized and entrenched.
- The business sounds silly.
- There is a lot of controversy surrounding the business.
- It has been spun out of a larger company.
- Wall Street doesn't follow it or care about it.
- The business supplies something people need to continually buy.
- Management is buying shares, or the company is repurchasing its stock.
- It uses technology to cut costs or add value for customers.
- Company or its industry is grabbing a lot of headlines.
- It is the hot topic of conversation at happy hour.
- It is being touted as a revolutionary company that is the next great investment.
- It has a cool, futuristic name.
- It is diversifying too much, diluting its competitive strength.
- It is a middleman and has a limited number of clients.
The second key principle in Lynch's investment philosophy is that you should do your homework and research the company thoroughly. "Investing without research is like playing stud poker and never looking at the cards." He recommends reading all prospectuses, quarterly reports (Form 10-Q), and annual reports (Form 10-K) that companies are required to file with the Securities and Exchange Commission.
If any pertinent information is unavailable in the annual report, Lynch says that you will be able to find it by asking your broker, calling the company, visiting the company, or doing some grassroots research, also known as "kicking the tires." After completing the research process, you should be familiar with the company's business and have developed some sense of its future potential.
Once you have done your research on a company, Lynch believes that it is important to set some realistic expectations about each stock's potential. He usually ranks the companies by size and then places them into one of six categories:
- Slow Growers
- Stalwarts
- Fast Growers
- Cyclicals
- Turnarounds
- Asset Plays
The third main principle of Lynch's stock-picking approach is to focus only on the company's fundamentals and not the market as a whole. Lynch doesn't believe in predicting markets, but he believes in buying great companies - especially companies that are undervalued and/or underappreciated.
Lynch advocates looking at companies one at a time using a "bottom up" approach rather trying to make difficult macroeconomic calls using a "top down" approach.
Lynch believes that investors can separate good companies from mediocre ones by sticking to the fundamentals and combing through financial statements. He suggests looking at some of the following famous numbers:
- Percent of Sales
- Year-Over-Year Earnings
- Earnings Growth
- The P/E Ratio (Lynch's favorite metric)
- The Cash Position
- The Debt Factor
- Dividends
- Book Value
- Cash Flow
- Inventories
- Pension Plans
The last key principle of Lynch's investment philosophy is that you should only invest for the long run and discard short-term market gyrations. Lynch has said, "Absent a lot of surprises, stocks are relatively predictable over ten to twenty years. As to whether they're going to be higher or lower int wo or three years, you might as well flip a coin to decide." Nonetheless, Lynch sticks with his philosophy, adding: "When it comes to the market, the important skill here is not listening, it's snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story has not changed."
Lynch's investment philosophy is very similar to Buffett's stock picking approach. Lynch said, "And Warren Buffett, the greatest ivnestor of them all, looks for the same opportunities I do, except that when he finds them [great businesses at bargain prices], he buys the whole company."
Lynch said, "The basic story remains simple and never-ending. Stocks aren't lottery tickets. There's a company attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you'll do well."
