Investing is so elementary and yet only few people are able to make money over long period of time and survive the vicissitude of the market. Most people try to make a quick buck chasing stock tips from punters in the market and unfortunately end up losing their shirts. For most investors stock symbols are just ticker symbols moving across their computers. However for investors willing to perform a little due diligence before investing I recommend a disciplined path for investors to follow and that is a value investment philosophy which has a long history of delivering excellent results with very limited risk. Value Investing is basically the strategy of buying securities for a price far below their underlying value and trying to minimize their downside risk. Simply put, the cheaper you buy a stock the less one stands to lose and less is the downside risk. So the risk is not in the volatility of a stock but in the price at which you buy a stock. Risk as defined my most value investors is the permanent loss of capital and not the volatility of the stock. There is no reason to be worshipful of stock market
quotes. They are simply prices to be taken advantage of or ignored,as the case may be. This is what the old master Benjamin Graham, the father of value investing meant when he said the average investor would be better off without constant stock quotes — because the average investor makes too much of these prices.One common characteristic of value investors is that they take advantage of the volatility and that enables them to buy stocks at a cheaper price. The cheaper the merrier is the credo, of course the stocks must have a strong underlying fundamentals.
As defined by Graham and Dodd, an investment operation is the one which upon thorough analysis promises safety of principal and a satisfactory return. Operation not meeting these requirements are speculative. The vital parts of the definition are "thorough analysis" and "safety of principal."
Thorough analysis involves studying various quantitative and qualitative aspects of the business and estimating the intrinsic value of the business and then waiting to buy it a significant discount.
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
"We think the very term ‘value investing' is redundant. What is ‘investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening)."
Two Basic Value Investing Tenets
1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can traded recklessly. Most investors don’t even realize that they are not investing and have become speculators by playing a "greater fool game" buying overpriced securities and then hoping to find a greater fool than you to sell it at a still higher price. Graham used what has become a famous metaphor called "Mr. Market" to explain how the stock market works. It is still the best way to understand how the stock markets work and how one should take advantage of the manic-depressive Mr. Market. The concept of Mr. Market goes like this : Imagine that in some business you own a small share that cost you around 1000 rupees. Mr.Market is one of your partners and is very obliging indeed. Everyday he comes to you to and tells you what he thinks your share in the business is worth and on that basis offers either to buy from you or sell you an additional interest in the business. The catch is that Mr. Market is a very strange dude and does not always price your share of business the way a sensible businessman would appraise. Instead his mood swings from being euphoric some days and the other days he is very depressed. Everyday he comes to you and offers you deal depending on his mood. Sometimes he might want to overpay for a share of your business and sometimes he might offer you an opportunity to sell you his part of the business at a ridiculous price far below its underlying value. Since you know the worth of the business based on fundamentals you are free to accept his offer or ignore him if you don’t like the price. The choice is simply yours. The more manic depressive Mr. Market is the more the more opportunity you will have to take advantage of him. Even though he might have wild mood swings he is a good business partner to take advantage of. In a nutshell, if you find a company that he is offering for less than it is worth, take advantage of him and buy a truckload of those shares as long as you have a strong conviction of what is the company's true worth. Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham's "The Intelligent Investor". That is the way most of the legendary investors like Benjamin Graham, Warren Buffet , Charlie munger et al made a fortune, buying partial interest in business at dirt cheap prices by taking advantage of the Mr. Market.
2)Margin of safety is the most critical aspect in value investing and is the most widely shared tenet among the value investors. Graham's definition of margin of safety is essentially the discrepancy between price and underlying value of the business. Margin of safety is required not only to limit the downside risk but also because of our inability to predict the future and the inherent biases in the investors which causes them to commit mistakes. Having a margin of safety is critical to a disciplined approach towards investing because it acknowledges the inherent flaws that we as humans have. It is like an insurance policy which helps to mitigate the damages caused to investors by some stroke of bad luck, imprecise and over-optimistic estimates or the vicissitudes of the economy and the stock market. Valuing a business is an art and not science because the value of business depends on numerous factors and cannot be captured by a mathematical equation and one can only come up with a ballpark estimate of the value of a business based on the assets and earnings power of a business.
According to Graham, "The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company's prospects. If these are bought on a bargain basis even a moderate decline in the earning power need not prevent the investment from showing satisfactory results,the margin of safety will then have served its purpose."
Buffett describes margin of safety in terms of tolerance. "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks cross it. And that same principle works in investing.
How large should be your margin of safety? Here's how it works: Suppose you appraise the value of a stock to be around 100 rupees and the stock is trading at 60 rupees then your margin of safety is 40 percent. Now the appropriate size of margin of safety required depends upon the underlying qualitative and quantitative aspects of the business and the level of confidence one has after performing adequate due diligence on the fundamental aspects of the business.
The quantitative analysis involves studying the key financial ratios ushc as return on invested capital, profit margin, debt –equity ratio, earnings power and cash generating capacity of the company. The qualitative aspects cannot be ignored as no business operates in vacuum and therefore it is necessary to study the competitive scenario in which the business operates and the actions of the customers to which the business caters to.
There is no secret to investing as every important aspect of investing is available in the public domain. For more wisdom on the art of investing refer to the book "Security Analysis" by Graham and Dodd, also known as the bible of Value investing. Though to some the book might seem outdated but its wisdom are very much applicable in today's market.