Art of value investing

VALUE is a subjective and complex concept. There may be things that have great value to some of us but mean little or nothing at all to others.
Recently, I came across a website called Value Quotes (www.valuequotes.net). It has a long list of quotes of some of the greatest thinkers of all times on the meaning of value, in both material and philosophical terms.
While some of the quotes there were quite abstract, most dictionaries usually take the materialistic meaning and define value simply as the monetary or material worth of something, or that value is a fair price or return for something exchanged.
Yet, even the best brains among us often cannot agree on the value of the same thing. Nowhere is this more visible than in the stock market, where intelligent people make decisions every day about which stocks to buy or sell. This article will focus on the philosophy of value investing.
Essentially, the value investor searches for companies he believes to be undervalued. He is the quintessential bargain-hunter who will scour the market in his search for good deals.
Before we go further, I would like to clear some possible misconceptions. Value investors are not the bargain-hunters often cited in media reports, who appear mysteriously on some days to trigger sudden rebounds in the market.
That is usually the work of short-term traders looking for quick profits. True value investors are buy-and-hold investors focused on long-term gains. Value investing is also not about buying cheap or bombed-out stocks.
It is about finding stocks that, for some reason or the other, are incorrectly priced by the market against their 'fair' or intrinsic values. By this measure, a high-priced stock could be a bargain while a penny stock might not.
The realm of value investing has to be credited mainly to the work of Benjamin Graham, a successful professional investor and influential academic widely regarded as the father of value investing.
GRAHAM'S TECHNIQUES
Together with David Dodd in 1934, Mr Graham published Security Analysis, still in print and considered as the bible for serious investors. Drawing from his personal experience of the devastation caused by the Great Crash of 1929, Mr Graham developed quantitative techniques that expounded the importance of diligent number crunching in the investment decision process. Basically, he developed a rigorous screening methodology.
In fact, it was Mr Graham who popularised the use of many of the financial tools we are familiar with today - price-earnings (PE) ratio, debt-to-equity ratio and book value. While Mr Graham may not be an immediately recognisable name, he is held in the highest esteem by someone who is.
Warren Buffett, a student of Mr Graham and widely regarded as one of the world's greatest investors, attributes much of his success to his mentor. Besides sophisticated screening tools, Mr Graham developed an investment philosophy that has withstood the test of time.
First and foremost, he believed investors have to approach stock investments as though they are seeking to buy or become a partner in the business. Mr Graham published his second book, The Intelligent Investor, in 1949.
POWERFUL CONCEPT
According to Mr Buffett, there are two other essential things all investors will gain from reading it - the concepts of 'Mr Market' and 'Margin of Safety'. The concept behind Mr Market is a simple but powerful idea. It is a story Mr Graham often related to describe how an investor should view market fluctuations.
Think of Mr Market as one of your partners in a business. He is an eccentric person ruled by his emotions, which can swing from amazing optimism to overpowering depression. Each day, Mr Market will turn up and offer to buy your share or sell you his share in the business at a price that corresponds to his mood, even though there has not been any fundamental change in the business.
On some days, Mr Market feels exhilarated over the prospects of the business and is willing to offer you a very high buy-sell price. On other days, he sees only doom ahead for the business and offers a sharply lower buy-sell price. But temperamental as he is, Mr Market does not seem to mind if you decide not to accept his offer and will be back again the next day with another buy-sell price for you.
The point of Mr Graham's story is that the stock market is there for investors to take advantage of. As investing behaviour is heavily influenced by the emotions of greed and fear, there will be times when you will be presented with opportunities to buy or sell stocks at particularly attractive levels.
Of course, the danger is that you unknowingly fall under the influence of Mr Market and find yourself swayed by the emotions of the herd. While there is the possibility that the herd may be right, Mr Graham's point is that to be successful, an investor has to remain rational and make independent decisions about the value of his investments.
Herein lies the problem as most investors - even professionals - usually will have differing values that they place on the same stock. This largely depends on their methods for calculating intrinsic value.
Acknowledging the possibility that his computations may be flawed, or that an external event could occur to affect the stock valuation, Mr Graham introduced the concept of Margin of Safety. This means making sure you have some room for error in your estimate of a stock's intrinsic value by buying at a sufficiently big discount.
Mr Graham believed that a true margin of safety is one that can be demonstrated by figures, persuasive reasoning and reference to actual experience.