“All Intelligent Investing is Value Investing”




Dear Investor,

These words were spoken by Charlie Munger, sometimes called the “brains behind Warren Buffett”.

I completely agree.

If you follow the standard investing advice of “buy low, sell high” to its logical conclusion, you will discover that at its heart, value investing is the only reliable way to invest profitably over the long term.

The goal for an investor is to acquire more than what he is paying for. He goes on to add that one must value the business in order to value the stock. Sometimes, the value is derived from the current operations and assets. At other times, the future earnings power and market position of the company contributes to the value.

A large proportion of the stock market investors are clueless about valuations. Stocks continue to confound the best and smartest among us. Most investors in the stock market today are driven by greed and lure of short term profits. Herd mentality drives their stock investments. Valuing stocks is not their primary concern.

But what of the investor who takes time to understand the fundamentals of business and value investing before investing in stock? Are they making the best stock investments they can? Do they fare any better?

The Real Value TRAP: Not All Value Investing is Intelligent Investing

There is a saying that either you get value investing completely or you do not get it at all. There is no middle ground.

You can study the principles all you want, learn all about financial ratios and cash flows and balance sheets. You can run projections years into the future, find the stocks with proper margin of safety, and even study the past value investing greats and model your investment styles around theirs. It is not enough.

You comb the best financial blogs and stock market websites for stock advice and find terrific undervalued stocks. You invest in stocks that match all your criteria. You can still end up losing money.

I used to say: stock market investing is simple. Look for great valuations, consider risk, be aware of the catalysts and know your sell price before you buy, and sell when the stock proves your investment thesis and reaches your sell price. Profit. Repeat.

The problem: A lot happens between the time you buy a stock and the time you sell the stock.

Sometimes, every thing goes according to the plan. These times are rare. It is never a straight line to profits. What if competitors compete? (the horror!) What if the management is crooked? What if there is a recession? What if profits or revenues do not match your expectations? What if everything goes right but the market is still indifferent or even sours further on the stock? Not to mention, what do you do when you find out that your investment thesis was flawed? Do you have the confidence to stay with your investments if there is a sudden stock market crash?

Your fortune will be made or lost based on how you react at these critical decision points.

First things first.

This is the Only Secret to Picking Consistently Profitable Stocks

There are two ways you can make money in the stock market

  1. You can buy stocks without regard to price and fundamentals, hoping there will be someone ready to buy your stocks back from you at a higher price. This is also called the greater fool theory. Or,
  2. You choose only those stocks to buy where you have reasons to believe they are worth more than the price they are selling for today.

1. The Greater Fool Theory of Investing

At Value Stock Guide, we do not concern ourselves with the greater fool way of “investing”. There are countless websites, services and advisors who can “help” you with this method if this is how you choose to invest your hard earned money.

Any service or website that talks about charts, momentum investing, hot stocks, and technical analysis, without a word about the fundamentals of the company, follows the greater fool theory of investing.

This method is also called speculation.

I wish you as my reader stay away from this. It is more profitable to trade against a speculator than to be a speculator. Truthfully, speculation creates excesses in the stock market, both on the upside and the downside, which a thoughtful and intelligent investor exploits for his or her own benefit.

Profiting from the speculators is a more reliable way of building wealth than speculating.

2. Investing in Stocks that are Worth More than they are Selling for

It is hardly surprising that once we bring rational thought to the process of investing, your chances of successful investment goes up considerably.

The rational process in investing can be broken down into 3 steps

Simplified 3 Step Value Investing Framework

Simplified Value Investing Framework

The stock price is easy to determine. The market sets it and you can get it via the stock market quotation. Any stock broker will help you with this if you know the stock symbol or the ticker.

The difficulty lies in finding the intrinsic value of the stock.

How to Value a Stock Correctly (you are likely doing this wrong)

If you are like most other investors who pay attention to fundamentals of a business, you consider certain key financial ratios as a proxy for valuation.

This normally works when we look at the most commonly held stocks. These stocks tend to be large well known companies and have multiple Wall Street analysts covering them.

You are also not very likely to find true value stocks here.

I do not wish to underplay the importance of these financial ratios. They have been part of investors’ tool set for decades and for good reasons. They can very quickly tell you if a stock merits further due diligence or not.

But looking at these ratios does not make for a complete due diligence.

These ratios, or rules of thumb, can inform and guide your investment process. They should never be the only reason why you buy or sell a stock.

Here is the key takeaway I want you to remember. These valuation ratios work on a comparative basis, when you are looking at a typical steady state business. Value stocks, specially if you are investing in distressed assets or special situations, are NOT typical and not steady state. So use these metrics judiciously.

To find great value stocks, you need to go further than an average investor and really understand the business.

Estimating the Intrinsic Value of a Stock

To pay less than what a stock is worth, we need to start with judging what a stock is worth.

Never invested before and don’t know how to start? Read our comprehensive guide to how to invest in stocks.
  1. Learn the definitions
  2. Review basic stock market terminology
  3. Explore different world stock and commodity exchanges
  4. Practice investing with simulated stock market game
  5. Help teens invest and build a solid financial foundation

This boils down to understanding the value of the business. A stock after all is just a small claim on the business.

There are many academic theories and methods to estimate the intrinsic value of a company. Things like Dividend Discount Model, Multiples analysis, etc make for elegant ways of coming to a precise number.

But the only thing that really matters is “what will a sophisticated investor pay for this business”?

Who Exactly is this Sophisticated Investor?

A Sophisticated Investor

Details are Important for a Sophisticated Investor


The sophisticated investor is not an investor at all. At least, not in the sense we typically understand.

Investors are NOT the arbiter of values of businesses.

The value of a business is determined in the business market place. Not the stock market.

The value of the stock derives from the value of the business. (Every one gets this backwards)

The sophisticated investor therefore is a business owner, a competitor or another firm. And the value of the business is the value this business owner, competitor or another firm will pay for this business in return for the “owner’s earnings” or assets.

Keep in mind that a business owner is typically risk averse and unlikely to bet large amounts of capital solely in expectations of future earnings. He or she would require enough existing value in the business to cover a substantial part of the investment. Speculation is not a sustainable business practice. Existing assets matter and balance sheet strength is of great importance. They give the company options and leverage in the market place to effectively compete and grow or protect their market share.

Once you understand that the stock values are ultimately derived from the business values, investing becomes profitable, predictable and low stress. You can simply ignore what market does on a daily basis, which is just a sum of a million investors’ greed and fear, and focus on the only thing that matters – the business values.

The intelligent way to invest is to act as a business owner.

You Get This. But … It is Still so Hard to Invest Intelligently

It is not exciting. You feel like swimming against the tide because the crowd thinks you are wrong. Your spouse or colleague at work says “but everyone knows XYZ stock is hot and will take over the world …”. The financial media proclaims “this time it is different”!

It is very easy to doubt yourself and think that if everyone is doing it, it must be right.

To be mediocre is very alluring. Sure you do not become rich, but atleast you are playing the game, as well as almost every one else, and getting results that are no worse than every one else.

Worse, even if you wanted to go against the consensus and invest with original research and ideas, it is very difficult to do with professionally managed funds and other pooled products.

The professionals that you entrust your hard earned money to deliver the best possible returns for you are instead worried that if they do not perform as well as the average, you will move your account elsewhere. Result is a race to be average. Most funds are closet indexers, they aim for the average index returns (minus their fees). They get paid by the amount they have under management – not by the returns they deliver, and therefore they focus on not losing your account.

Wealth Advisors Underperform

Your Financial Advisor is Likely Wasting Your Money


To sum up, you cannot invest intelligently because,

  1. It is very uncomfortable and unnatural to human psychology, and,
  2. Professional investors that you trust with your money are more interested in keeping your money, not getting you the best results

Additionally, if you are like most individual DIY investors, you just do not have time or the training or the experience to do the deep research necessary to find great investments.

And finally, let’s say you are able to find great undervalued stocks from financial media or some investment blogs. You found time to research these stocks and made your picks. Do you know how to structure your portfolio to reduce your overall risk and maximize your gains?

(Great stocks will get you profits. A great portfolio will let you sleep at nights and make sure you do not panic and sell out of a great stock at exactly the wrong time!)

The best investment blogs or financial media is useless when it comes to portfolio management. There is no stock selection guide that tells you how much of the portfolio is made up of which stock.

So in many ways you are doomed to a life time of mediocre performances. Or you will take short cuts and assume a greater fool exists every time you need them. Or find the best stocks and still lose money.

You are an Investor, not a Gambler. There is a Better Way

Around the middle of the 20th century, there was a young investor named Benjamin Graham. He figured out a startling fact. Most investors do not make money in the stock market because they overpay for their investments.

The problem was (and still is), that investors assume there will be someone else to take the overpriced stock off their hands when they want to sell.

As Warren Buffett says in his 1987 letter to shareholders,

“If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

What if you refuse to be the patsy? What if you decide to only buy a stock if you can get it for less than its worth?

DECADE RETURNS 1930 THROUGH 2009

The following are 10-year annualized percentage returns for the S&P 500 Index, U.S. Large Cap Value, U.S. Small Cap and U.S. Small Cap Value. Returns are in %s.

Asset Class:

30-39

40-49

50-59

60-69

70-79

80-89

90-99

00-09

1930-2013

S&P 500 Index

-.1

9.2

19.4

7.8

5.9

17.5

18.2

-.9

9.7

Large-Cap Value

-5.7

12.7

18.4

9.4

12.9

20.6

16.8

4.1

11.2

Small-Cap

2.3

14.9

19.2

13.0

9.2

16.8

15.5

9.0

12.7

Small-Cap Value

-2.6

19.8

19.6

14.4

14.4

20.1

16.2

12.8

14.4

Includes reinvestment of dividends. Source: Dimensional Fund Advisors.

Value stocks consistently outperform the market. This is not in question. Study after study comes to the same conclusion. In fact there has never been a 20 year period where value stocks underperformed the market.

Still people do not value invest!

The Sure Fire Way to Beat the Market

Is to buy cheap stocks.

Easy to say, right? But how do you find cheap stocks?

Turns out, it doesn’t matter. You pick a metric. Any metric. Be it Earnings, or Book Value or Sales or Cash Flow. Then you can blindly buy the stocks that are selling at lowest price relative to the metric.

Value Investing Performance

Source: What Works on Wall Street, 3rd Edition(2005) by James P. O’Shaughnessy

Price/Earnings 1952-59 1960s 1970s 1980s 1990s 2000-2003
ALL Stocks 19.22% 11.09% 8.53% 15.85% 14.75% 5.91%
50 High P/E Stocks 19.27% 10.96% 2.26% 7.99% 16.99% -14.73%
50 Low P/E Stocks 21.84% 13.96% 8.89% 7.56% 13.58% 33.55%
Difference 2.57% 3.00% 6.63% -0.43% -2.85% 48.28%
Price/Book Value
50 High P/B Stocks 22.32% 13.13% 0.82% 1.97% 18.03% -31.17%
50 Low P/B Stocks 18.86% 11.49% 17.06% 13.15% 15.83% 25.68%
Difference -3.46% -1.64% 16.24% 11.18% -2.20% 56.85%
Price/Cash Flow
50 High P/CF Stocks 19.30% 8.02% -3.03% 8.77% 12.77% -27.77%
50 Low P/CF Stocks 18.71% 15.41% 13.57% 12.53% 12.86% 21.23%
Difference -0.59% 7.39% 16.60% 3.76% 0.09% 49.00%
Price/Sales
50 High P/S Stocks 14.96% 11.99% 5.82% -2.02% -2.46% -42.37%
50 Low P/S Stocks 20.85% 11.15% 14.80% 20.43% 13.80% 19.94%
Difference 5.89% -0.84% 8.98% 22.45% 16.26% 62.31%

This data is NOT adjusted for survivorship bias. Many value companies are cheap because they are troubled. The returns in the table include the companies that closed down or went bankrupt.

In fact, this value premium is a phenomenon that Fama and French, the proponents of the Efficient Market Hypothesis, had so much trouble explaining, that they wrote it off as an anomaly. (When facts do not fit the hypothesis, it is easier to use different facts).

The value premium exists because the market over reacts to any hint of trouble with a company. Investors (both individual and professionals) are quick to react when they realize they may end up being the “greater fool”.

A value investor realizes that most companies survive. If he keeps buying stocks cheaply, on average he will perform very well over time, even if a few of the investments do not work out.

BONUS: Even More Sure Fire Way to Beat the Market

Turns out, there is an even better entrenched “anomaly” in the stock market that curiously individual investors are more able to exploit than professional investors.

Small company stocks over a reasonably long time horizon, beat the large and mid company stocks and the overall stock market indices.

Just like Value Premium, there is a Size Premium

The reason this size premium exists is that smaller company stocks are less followed by professional analysts. Therefore, enough information gaps exist in this sector to create opportunities that can be exploited.

Further more, while individual investors are able to exploit these opportunities, professional investors might not be able to as these companies can be so small that any meaningful investment in the stock is not possible.

DOUBLING UP: Imagine if You Combine Value Premium and Size Premium Together!

Small Cap Value Stocks are the undisputed leaders when it comes to the stock market returns, and it has been this way every since we started tracking stock market returns based on asset classes.

In fact, the difference is so large and consistent, that a normal investor who invests in a large cap index fund such as S&P 500, is one of the biggest patsies in the stock market.

Fama and French (remember them!) data between 1927 and 2005 indicate the following returns from various asset classes:

Value

Growth

Large Cap 9.21% 6.17%
Small Cap 12.13% 5.77%
TSM:

6.72%

(see: http://www.moneychimp.com/articles/index_funds/why_sv.htm)

Luckily for us, the stock market is full of patsies investing in total stock market index funds or chasing hot new stocks (small growth).

This data is out there. The trend is consistent. The conclusions are beyond dispute. Still, the financial media, mutual fund industry, and the financial advisor community keep singing the praises of these index funds and keep creating more patsies

It is because these patsies exist, and in such large numbers, that value investors like us and Graham and Buffett can make tremendous profits in the stock market.

Can Individual Investors Like You Value Invest Like Buffett and Graham?

Yes. But you need to accept the following

  • Value investing requires discipline
  • Value investing requires patience
  • Value investing requires business understanding
  • Value investing requires willingness to go against the crowd
  • Value investing requires time and work to conduct proper research
  • Value investing requires long term investment horizon, and,
  • Value investing requires complete confidence in yourself (arrogance) and the willingness to accept when you are wrong (humbleness)

In this fast moving, act first ask later, ADHD world, these qualities are very rare.

Ask yourself this question: When you have a large portion of your net worth invested in the stock market, would you be able to go days and weeks without checking the market or your portfolio with your broker?

You will not be looking for “stocks for today”. The stock market values patience and the ability to hold a position long enough for it to become profitable. You will have to resist the urge to “do something”. Most profits come by waiting.

If you can detach from your investments enough to be able to do this, you can be more objective, have healthier relationship with your money, and will be able to sleep soundly at night. You have redefined risk from “what is happening in the market” to “how likely am I to lose money over time”, which although common sense, is not how most investors invest.

If you can do this, the results can be spectacular.

YES: Do You Want to Make Smart Stock Investments that Make You Lifetime of Profits?

Unlike other stock market blogs or investment advice websites, at Value Stock Guide you know exactly who is behind the stock investing advice you receive. I have spent decades in the stock market perfecting my value investment philosophy and deep value investing credentials. You can read about me in detail here.

No fluff, no idle chit chat. Just a relentless focus on profits. You can count on my best stock advice. My long term stock investments have typically beaten every stock market index and Berkshire Hathaway stock in the comparable period.

Value Stock Guide Portfolio Performance

Value Stock Guide Performance VS. Benchmarks

You want me to research and recommend the best stocks to invest in today for you so you can invest long term with confidence

  1. Get and review our past investment case studies
  2. Purchase one current recommendation to further evaluate if you want to join our community of long term value investors
  3. Check long term portfolio performance and register for Premium membership for our best investment advice and lifetime of profits

You are a DIY investor and just need some guidance to invest yourself

  1. Sign up for our newsletter (FREE) and get the Graham checklist to help you with a easy to use filtering process to find the top value stocks in the market today. You will also get stock investment ideas that we are in the process of evaluating so you have a pre-selected list of stocks to choose from
  2. Discover the 5 most common investing myths that you and most other investors believe in, that force you to accept mediocre returns.
  3. Read the Value Investment Guide on the site.




Here’s wishing you a lifetime of profits investing in the stock market.

shaileshpic_reasonably_small_optimizedsignature
Shailesh Kumar

FeaturedInStrip