I have traded Stocks, Options, and Foreign Exchange (Forex). I have scalped the EUR/USD pair, and I have spent numerous hours looking at chart patterns on various time frames for that perfect swing trade opportunity. I have made countless trading decisions using Japanese Candlesticks, Support/Resistance, and Momentum indicators. I have traded based on market sentiment and current events. In short, I have performed technical and sentimental analysis while trading securities. None of this is investing. It is all speculation.
Value investing is near and dear to my heart. I consider myself a value investor. It makes sense. It is proven (look at Warren Buffett). It is not “gambling”. I feel that I should blog about how value investors think by focusing on the top 5 lessons that I learned from Ben Graham (“father of value investing”) and Warren Buffett:
1. Speculating Versus Investing
In the first chapter of The Intelligent Investor, Ben Graham talks about the difference between investing and speculating. This is how Ben Graham defines investing, “An investment operation is one where, upon thorough analysis, promises safety of principal and an adequate return”. How does speculation work? “A speculator gambles that a stock will go up in price because somebody else will pay even more for it.” The stock price is what a speculator lives on. Graham claims that it is in the human nature to speculate, and that an intelligent investor should know when he/she is speculating vs. investing.
Graham said that there are 3 big unintelligent ways to speculate: 1. Speculating when you believe you are investing; 2. Speculating seriously instead of a pastime, when you lack knowledge and skill for it; 3. Risking more money in speculating than you can afford to lose. Furthermore, Ben Graham advised to put aside a portion (smaller the better) of your capital for speculating. He said never to add more money in this speculating account just because profits are rolling, and never mingle speculative and investment operations. Following Graham’s footsteps, I set up 2 separate accounts, one where I invest (seeking value and preserving capital), and another one where I speculate (trading options/forex) – never intermingling the funds.
2. Market Fluctuations
I have to quote this paragraph from Chapter 8 of the Intelligent Investor because it is that good. Graham says, “The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistake of judgement.” In this one paragraph, Graham summarizes how to survive a bear market. This goes hand in hand when Warren Buffett says, “Mr. Market is there to serve you, not to guide you”. It means that when you see blood on the street, don’t follow the crowd and start selling. When Mr. Market gives you a bargain, you buy! Here is a video from Berkshire Hathaway’s 1997 annual shareholder meeting, where Warren Buffett talks about this concept.
3. Three Philosophical Benchmarks
During the 1995 Berkshire Hathaway’s annual shareholder meeting, Warren Buffett outlined the 3 key investing principles that he learned from Ben Graham. First, look at stocks like businesses. This is the mentality that when you own even one share of a business, you are the owner of that entire business. Second, have appropriate margin of safety. This is the idea that when a road has a speed limit of 65 mph, the engineer actually designed it for 100 mph, accounting for that margin of safety. Same concept applies to valuing businesses. The market price of a business should be close to equity (i.e. assets minus liabilities) of the business. Another way to account for margin of safety is by applying a discount to the intrinsic value of the business. Third, proper attitude towards the stock market. You can say that you have the proper attitude when you become indifferent towards the swings in the market conditions. I discussed about this attitude in the previous bullet point. Here is another video, where Warren Buffett mentions these 3 principals.
4. Finding Value
Finding the value of a business is an art. I wanted to learn this art. So, I started watching videos, listening to podcasts, and reading books that specifically talked about what Warren Buffett looks for while investing. I noticed that Warren Buffett would frequently mention going through annual reports of companies before coming to a conclusion. So, I made it my goal to learn to read annual reports. I came across a book called Warren Buffett Accounting. If you are like me, who didn’t go to a business school, this book might just be the best place to start.
The book extensively discusses the 4 big principles that Warren Buffett uses while investing in companies/stocks. Warren Buffett has talked about all these principles either during shareholder meetings or during one-on-one interviews. Let me outline the 4 principles for you. I will get into the nitty gritty in a future blog post. First, vigilant leaders (financial statements showing low debt, high current ratio, Return On Equity (ROE) above 8%, leadership compensated based on long term goals). Second, long term prospects (ask yourself “will the internet change the way we use this product?”, buy and hold/minimize taxes). Third, stock stability (stability and growth of book value, Earnings Per Share (EPS), ROE, and look for competitive advantage – moat). Fourth, buy at attractive price (keep a wide margin of safety, low PE, low price to book ratio, set a safe discount rate, know the right time to sell if anything changes). Through this book, I learned to use the financial statements to find out details that prove or disprove how well the company is positioned in the market. Additionally, I learned to value companies. I trust my valuations and my margin of safety a lot more than that of a stranger who decided to upgrade or downgrade a stock. I no longer have to make decisions based on an analyst’s recommendation.
5. When To Invest
I used to be a speculator – timing the market for the next correction. Waiting for that low, so that I can sell high. Ben Graham, Warren Buffett, and Charlie Munger have all said that it is nearly impossible to time the market – that next stock market crash might be tomorrow or 10 years from now. You just don’t know. So, what should you do? When should you invest?
Anytime is a good time to invest. An intelligent investor doesn’t care about the swings in the market price. Graham says that as long as these 4 conditions are met, you can invest in a company: First, stock is selling at a reasonably close approximation to its tangible asset value. Second, a satisfactory ratio of earnings to price. Third, a sufficiently strong financial position. Fourth, the company’s earnings will at least be maintained over the years to come. Graham and Buffett both agree that if it is a good company, it is fine to pay a little premium. If you can’t find a good investment, hold onto your capital. Take a look at the cash that Berkshire Hathaway is sitting on. Yes, you are actively seeking investment opportunities, but that does not mean you go for each and every mediocre opportunity. As the market gets more expensive, you are going to have a tough time finding a bargain. Usually, as stock market gets expensive, interest rates are increasing in the background making bonds more attractive.
Let’s wrap it up. The important thing to take away is that a value investor’s goal is to first make sure the principal is safe, and then you want an adequate return on that principal. You are not chasing a hot tip. You are valuing a company by looking at the fundamentals. Your emotions are set aside. You care less about Mr. Market’s bipolar behavior. Price moves up and down, but you only care about the value of the business. You take advantage of Mr. Market when stocks are cheap. Buy and hold. Given that nothing changed fundamentally, you buy more as prices drop. Buy even more as prices drop further. That’s precisely how a value investor thinks. He/she takes advantage when the market misprices an asset.
Hope you learned a little and found this blog post helpful. We talked about the mentality of value investors. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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