If you are new to the world of the markets and are looking for a 'style', these value investing basics just might be for you.
It is reasonable to say that an individual should NOT become interested in this area if they dislike hard work or numbers. Quite simply, value investing for beginners will be hard work. Both Graham and Buffett suggest that any investor requires a good background knowledge in accountancy and financial history. I would argue that this counts double for the contrarian approach.
In simple terms, there are four value investing basic beliefs. These are that:
a) the market capitalisation of a company is based upon the assets owned by a company and that this can be calculated using the financial and business numbers
b) the price of a company in the market is determined by supply and demand factors. Benjamin Graham called this 'Mr Market'. These prices are determined in part by hopes and fears, irrational reactions and overall market conditions
c) Thus, the valuation of a company in the market is frequently over or under the value of assets. A great place to see this in action and learn about the swings around net asset value is in the United Kingdom's investment trust market.
d) In time, the market capitalisation will revert (higher or lower) to the average price. This may take months, years or decades. It is often the case that true values of a company will over-react and shoot too far. This may mean extra profits or losses for an investor as prices are buoyed by confidence or slashed in despair.
Warren Buffett considers himself to be '85% Ben Graham' which suggests that a keen eye on the actual worth of a stock is vital to long term success.
There is little doubt that an approach based on the intrinsic value of an asset has a lot of appeal intellectually. It is, however, difficult to apply in the real world these days.
Why?
Simply because most major markets, and therefore the companies being traded in them, are valued at 'multiples' of their assets. This is known as a Price/Earnings ratio. And at times of economic growth, much of the market might be valued at 15 to 20 times earnings!
Finding a company valued at less than the assets on the balance sheet is not easy in those conditions. For a superstar like Warren Buffett who must have hundreds of other things to do involved with existing businesses, it is easy to wait.
However, for the individual interested in investment, sat on the sidelines watching and waiting while the rest of the investment world is busy making money, a very strong sense of discipline is required. It is not easy to wait all year, follow markets and stocks closely and NOT make an investment! Especially in a market rising strongly.
Whilst these value investing basics are very basic, it is worth noting that this is the overview of the theory. Quite obviously, there is more to it than this (this article might help, as may The Graham Investor website).
Becoming a profitable value investor takes skill, practice and dedication.
For more about this subject:
What Is Value Investing?
Problems With The Value Investing Approach
The Value Investing Rules Of Ben Graham
The Good And Bad Of A Value Investing Strategy
What Is Asset Stripping?
Value Investing With Warren Buffett
Value Versus Growth Investing