WCM Educational Recap #11: Intro to Value Investing

Recapped by Morgan Tannis

Welcome back to the Western Capital Markets blog! This week, we dive into the history and fundamentals of value investing and find out how firms like Berkshire Hathaway, The Baupost Group, and Abrams Capital consistently beat the markets.

Value Investing in Three Steps

1. Calculate a security’s intrinsic value (to calculate intrinsic value, use a DCF model, we cover DCF’s in our blog post on valuation, check it out!)
2. Buy when the market price drops below the security’s intrinsic value plus a margin of safety
3. Sell when the market finally corrects and accurately prices, or irrationally overprices, the security

Before taking a granular look at the value investing process, let's find out where the philosophy began.

History and Basic Concepts

Origins of Value Investing: The Graham and Buffet Story

• Ben Graham, “the grandfather of value investing” was a money manager and a lecturer at Columbia Business School from 1928 until 1955
• In 1934, Graham published Security Analysis, and in 1949, his seminal work — The Intelligent Investor
• After reading The Intelligent Investor, a 19-year-old Warren Buffet wrote a letter to Graham and asked to be his pupil at Columbia, the rest is history

One of the tenets of Graham and Buffet’s approach is a concept called intrinsic value.

Intrinsic Value

• Intrinsic value is the objective value of a company based on fundamentals like assets and profits
• A security’s intrinsic value is not always reflected by its market price, which is often inefficiently speculative and irrational

To find great value opportunities, investors like Buffet search for good business trading at low prices.

What Makes a Good Business?

• Qualitative factors: Reliable management, high customer retention, barriers to entry
• Quantitative factors: Low multiples, discount to peers, strong margins, growing top line

Qualitative and quantitative factors are closely linked and cannot be analyzed separately.

Six Characteristics of Underpriced Assets

1. Little known and not fully understood
2. Fundamentally questionable on the surface
3. Controversial, unseemly, or scary
4. Deemed inappropriate for “respectable” portfolios
5. Unappreciated and unpopular
6. Recently the subject of disinvestment, not accumulation

Now that we know a bit about the history of value investing and its fundamental principles, let’s look at a concept all great investors understand: risk.

Risk

Understanding Risk

• Risk is the likelihood of losing money
• When considering investments, assess return in proportion to the risk
• Forms of non-financial risk include the risk of failing at a goal or at work, or unconventionality

To avoid unnecessary risk, value investors take a defensive approach to executing buy/sell orders.

Principles of Defensive Investing

• Exclusion of Losers: By holding high standards for potential ideas and conducting thorough due diligence, defensive investors increase their margin for error
• Avoidance of Bad Years: By holding a diversified portfolio, defensive investors limit their exposure to sustained bear markets

In addition to taking a defensive approach to investing, value investors like Buffet maximize gains by exercising patient opportunism and executing only on the best ideas.

It’s Like Baseball, but Easier

• Patient opportunism is about waiting for the perfect idea and knocking it out of the park
• Because there are no strikes in investing, value investors can let hundreds of subpar ideas fly past without having to walk to the bench

To exercise patient opportunism well, you need the right temperament.

The Right Temperament

• Investors tend to outperform when they wait for investments to come to them rather than chasing after them
• Patient opportunists select ideas from a list of potential targets and avoid getting attached to any one idea
• Strong investors are not swayed by irrational market euphoria or panic

Knowing about the principles of value investing and the concept of risk, we can now examine the fundamentals of building an investment portfolio.

How to Build a Portfolio

1. Generate a list of potential investments based on risk tolerance and return goals
2. Calculate intrinsic valuations and the risk/return ratios
3. Compare market prices to intrinsic valuations to determine which investments offer the highest margins of safety
4. Estimate associated risk by determining how the inclusion of each investment affects the risk of the entire portfolio

Now that we understand what risk is and how to deal with it through principle and temperament when building a portfolio, we’re going to explore a simple concept that just so happens to be the eighth wonder of the world.

Compound Interest

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it” — Albert Einstein

Simple Interest

• Holder gains interest on the principal
• Borrower does not have to pay interest on the interest accrued
• Simple Interest = Principle Amount * Annual Interest Rate * Years
• $10,000 invested at a 5% annual interest rate for 20 years earns $10,000 in simple interest

Compound Interest

• Holder gains interest on the principal and accumulated interest from previous periods
• Borrower must pay interest on the principal and interest accrued
• Compound Interest = Principle Amount * (1 + Annual Interest Rate)^Years — Principle Amount
• $10,000 invested at a 5% annual interest rate for 20 years earns $16,533 in compound interest

Investing by compounding is like rolling a snowball down a hill. It starts small but eventually grows to a tremendous size. Instead of wasting capital on speculative bets, allocate it to value opportunities or even a broad market index, and simply wait.

Key Takeaways

• A strong value investment requires great fundamentals, undervaluation, and the character and conviction to go against the crowd
• To avoid unnecessary investment risk, apply defensive investing principles and exercise patient opportunism — it’s like baseball, but easier!
• Do not underestimate the power of compound interest to generate outsized returns across time

Thanks for reading, we hope you learned something new! Drop a comment below to continue the conversation if you have any questions to ask or insights to share about value investing.