Finding valuable investments in the Stock Market
"The Stock Market shows the price people are willing to buy/sell a stock, not its value."
The Intelligent Investor
"By far the best book on investing ever written."
Warren E. Buffett
Value Investing
The Intelligent Investor
The Intelligent Investor is the person who looks for discrepancies between value and price. The objective is to buy an asset which is currently underpriced.
Benjamin Graham's principles
- A stock is not just a ticker symbol; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. When you buy a share, you are buying a part of the business.
- The market is a pendulum that forever swings between unsustainable optimism (share price becomes expensive) and unjustified pessimism (share price becomes cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
- The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.
- No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the "margin of safety" -never overpaying, no matter how exciting an investment seems to be- can you minimize your odds of error.
- The secret of your financial success is inside yourself. If you become a critical thinker who takes no Wall Street "fact" on faith, and you invest with patience confidence, you can take steady advantage of even the worst market conditions. By developing your discipline and courage, you can refuse to let other people's mood swings govern your financial destiny. In the end, how investments behave is much less important than how you behave.
A model based on protection, not in prediction
"The analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them."
Security Analysis
In 1934 Benjamin Graham and David Dodd published Security Analysis
Graham and Dodd suggested that investors / security analysts should look at the value of the operating business behind the security, instead of looking at the future earning possibilities since those were influenced by many other factors.
A quick example: Graham and Dodd would look at the Net current asset value of a certain company divided by the number of issued shares and if the result was lower than the current share price they would call this a "bargain issue".
Let me explain why: the net current assets are those that can be converted in cash in the short term (12 months). Let's say the company is valued in the market (share price times number of shares) at $40 million, but the financial report from the company shows the net current asset value is $50 million. That means you could buy the company for $40 million and sell the assets individually for $50 million; that's called asset stripping. But the bottom line is that the business is worth more than what the market is saying (value > price).
In other words, the market is being inefficient since the price and the real value of the company differ. In the example above the company is underpriced (we would buy); but the opposite can also happen and then you don't want to buy, you don't want to pay $5 for something that is worth only $3.
That said, I would like to introduce you the "person" you'll be dealing with: Mr.Market.
Getting to know "Mr. Market"
In the short run, the market is a voting machine. In the long run, it's a weighting machine.
Warren E. Buffett
The stock market is probably the only place where some people buy when it's expensive and sell when it's cheap. There are basically two emotions behind these trends: greed (I want to make more money) and panic (I don't want to lose money). By following the trend of the market up (bullish) or down (bearish) you let the market dictate your investment behaviour. In other words, by doing that you are following the herd.
But you don't have to do business when Mr. Market wants, you can wait until he offers favourable conditions. Graham presented the market as the person you make business with, logically you buy from Mr.Market when is cheap and don't buy (sell) when it's expensive.
In order to build this "special relationship" with Mr. Market you have to control panic and greed.
How to avoid panic: Well, if you follow Graham advice you would invest in stocks where you can have a certain "margin of safety", the lower price you pay the better.
How to avoid greed: Find out the intrinsic value of the company. Warren Buffett says he reads the financial report of
the company and decides how much he would pay for the whole business, if the value matches the current market price he invests on it.
But look at it the
other way round, let's say you hold shares in company XXX and you know that the business is overpriced in the market. That means the market is being
inefficient, people are buying X for $10, when it's actually worth $4.
What would you do if I offer you $100.000 for a car that's worth $4.000?
Option A: you would sell it without a doubt
Option B: wait to see if I offer you $110.000
Believe it or not a lot people go for Option B in the stock market. The most recent example:
"dot com bubble".
My approach: I always go for what I call "double margin of safety". I look for stocks that give me some margin of safety and I invest with money I can afford to lose. Although it would be a big set back, my lifestyle wouldn't change if I lose all the money I have in the stock market.
Warren Buffett: Graham's most famous student
"The basic ideas of investing are to look at stocks as business, use the market's fluctuations to your advantage, and seek a margin of safety.
That's what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing."
Warren Buffett
Warren Buffett is with no doubt the most famous Graham's student, Buffett has updated Graham's teaching to the current investment enviroment. There's no much more I can say about the "Oracle Of Omaha" that hasn't been said already.
In Alice Schroeder's "The Snowball: Warren Buffett and the Business of Life
If you click the following link you will find all Warren Buffet articles, books, quotes and videos I've collected during this time.
No need to say Warren Buffett is a must-read if you are interested in investment