WCM Educational Recap #8: Introduction to Value Investing

Recapped by Kaede Kusano

Value Investing

This week, we went through an overview of the history and fundamentals surrounding value investing including investment approaches, price & value, and risk.

Investment Approaches

Intrinsic Value vs. Market Price

Intrinsic value is the fundamental, objective value of a company or asset based on facts (e.g. assets, earnings, profit). The foundation of a successful investment is an accurate estimate of its intrinsic value. While market price is based on speculative factors and people’s sentiments and decisions. Many uncontrollable factors go into market price including psychological and manipulative effects, resulting in the volatility in market price over time.

What is Value Investing?

Value investing concentrates on the difference between the intrinsic value and the market price. Value investors try to capitalize on the difference by determining a security’s current intrinsic value and purchasing it when its price is low. Then in the future, the security will be realized at its intrinsic value, resulting in large profits.

Key Characteristics of Value Investing:

1. Emphasizes Tangible Factors
2. Security is Undervalued
3. Margin of Safety

Value Investing Origins

Ben Graham, a lecturer, author, and money manager, is generally recognized as the grandfather of Value Investing. He focused on companies with consistent financial history and attractive outlook, strong management, a defensive business model, and limited obsoletion risk.

Ben Graham’s Central Approaches

1. The higher the price rises above the instinct value, the higher the margin of safety.
2. Net current assets should be less than the equity value.
3. Diversification; spread risk over the portfolio.

What is Growth Investing?

Growth investors invest in securities in which they believe have the potential for rapid growth in the future. It is highly variable and risky because it requires the consideration of all future events in the market. Growth investors typically adopt aggressive tactics and elevated risk in the pursuit of above-average gains because their goal is to maximize profits within a relatively short time frame.

Value vs. Growth Characteristics

Value Stocks:

• Lower P/E ratio
• Lower P/B ratio
• Slower earnings growth
• Higher dividend yields
• Looks at the company’s value today

Growth Stocks:

• Higher P/E ratio
• Higher P/B ratio
• Faster earnings growth
• No (or low) dividend yields
• Looks at the company’s value tomorrow

Price vs. Value

The Relationship Between Price and Value

Price does not determine or equal value. Many psychological and technical factors go into market price fluctuation (such as speculation, opinions, etc.) that are not correlated with value.

Bubbles

In a bubble, the relationship between price and value is ignored. There is a large discrepancy between market value and fair value; this creates a large increase in price over a short amount of time. Bubbles often feed off the Greater Fool Theory which states that the price of assets is not determined by intrinsic value, but rather the assumption that there will always be a “greater fool” willing to pay a higher price.

The Lifecycle of a Bubble:

A. Stealth Phase: Smart Investors enter while the asset is underpriced.

B. Awareness Phase: Institutional Investors enter and there is a price increase.

C. Mania Phase: The public enters and there is a massive price increase.

D. Cool Down Phase: Investors rapidly sell and the price crashes.

Outsmarting the Market

Who is a Second-Level Thinker?

A second-level thinker is identified as someone who has superior insight, intuition, sense of value, and awareness of psychology to beat the market. Their goal is to beat the average investor, not just the market, thus they must find a unique edge. It is inherently impossible to profit off of the market if you are investing exactly like everyone else.

Second-level thinkers depend on market inefficiency — the belief that market prices are incorrect, which draws on the discrepancies between market price and intrinsic value. An inefficient market may result from the absence of information, investors’ opinions, arbitrage, and delayed reactions.

Contrarianism?

Contrarianism is doing the opposite of what the majority or “herd” is doing. However, it is difficult to execute because it is psychologically difficult to see a trend go against your belief.

The most profitable investment action by definition: You’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high)

What Makes Good Investment?

A good investment is a good business at a good entry point. In a good investment, both qualitative and quantitative aspects are required. Qualitative feeds the quantitative, while quantitative is evidence that the qualitative exists. Context is also important as some industries have unique properties or quantitative figures to consider.

Qualitative aspects: Reliable management, high customer retention, barriers to entry

Quantitative aspects: Low multiples, cheap relative to peers, strong margins, growing top-line

Risk

Risk is the likelihood of losing money, not volatility. Most smart investors want to avoid or minimize risk; however, if you are completely avoiding risk, you may also be avoiding returns. When you are considering an investment, you want your decision to be a function of both the risk and the potential return; you need to be compensated for risk by higher potential returns. The mains risks of investing are losing money permanently and missing an opportunity.

Defensive Investing

Defensive investing focuses on minimizing or avoiding losing investments over gaining large returns on wining investments. Oaktree Capital utilizes this method. In good years, Oaktree performs inline or even below the market. But in bad years, Oaktree greatly outperforms the market.

Principles of Defensive Investing:

• Exclusion of Losers: unprofitable investments will occur, but can be minimized (executed through due-diligence, high standards, and margin of safety)
• Avoidance of Bad Years: Bad years are inevitable, so limit the portfolio’s overall exposure (executed through diversification, limited risk, and a focus on safety)

The Market as a Pendulum

Determining what stage the market is in is subjective.

Bull Market Stages

1. A few forward-looking people begin to believe things will get better
2. Most investors realize improvement is taking place
3. Everyone concludes things will get better forever

Bear Market Stages

1. A few thoughtful investors recognize that things will not always be rosy
2. Most investors realize things are deteriorating
3. Everyone is convinced things can only get worse

Patient Opportunism

Patient opportunism is the strategy of waiting for solid bargain investments to come along. Opportunists believe that the best way to buy is when prices are low because if you purchase at a high price, you are missing out on the potential for higher gains moving forward. Investors tend to outperform when you wait for investments to come to you rather than go chasing after them.

Warren Buffet’s Philosophy

Investors have an unlimited amount of strikes when searching for opportunities. Therefore, they can pass on opportunities until they find an excellent one. You can wait for the best pitch, then “step up and hit it” and hopefully hit a “home run”. The only penalty is a missed opportunity.

Understanding Your Environment

It is very important to determine if you’re in a low vs. high return environment. Investors look for profitable opportunities with controlled risk. You want to take on risk when others are fleeing from it, not when they are competing with you to do so. During recessions, there are many opportunities for generous returns through purchases at low prices (because many people are forced to sell) and are typically earned with low risk.