As a young man, I nurtured an increasing interest in the stock market by reading biographies of successful investors. Investors such as Ronald Perelman, Harold Simmons, Carl Icahn, Warren Buffett, Charlie Munger, John Templeton, Sam Zell, and Ted Forstmann fascinated me, and I read everything I could on their business exploits. The common link between these, and many other, successful investors was their ability to identify value, i.e., assets which could be purchased for less than their intrinsic worth.
It was only when studying the career of Warren Buffett was I exposed to the application of bargains in the stock market. Buffett learned of the “value” approach to stock selection from reading Benjamin Graham’s books Security Analysis and The Intelligent Investor. To Graham, who is considered the father of value investing, there were two prices for a stock. The first is the market quotation, and the second is what a prudent buyer would pay for the entire business, the stock’s “intrinsic value”. Graham suggested that an investor seek stocks which are selling significantly below their intrinsic value. This difference between a stock’s value and its price is what Graham referred to as a “margin of safety”. As legendary investor Seth Klarman stated: “A margin of safety is achieved when securities are purchased at a price sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.”
The value approach is intuitive to many, but difficult to apply. This is especially true when it comes to common stocks. The difficulties may explain why so few professional and amateur stock market participants do not follow the value philosophy. For one, the identification of bargains takes a lot of work. Secondly, valuing companies is difficult and subjective. The biggest difficulty, however, is psychological. The existence of second-by-second market quotations can lure otherwise prudent businesspeople into incredibly irrational behavior. An example of this is the dot-com mania of the late 1990’s, where individuals and professionals were purchasing shares in companies with no earnings and few tangible assets at incredibly lofty prices. Inevitably, these investors suffered massive losses. Sadly, I continue to meet enterprising businesspeople who have not purchased a stock in 15 years. These businesspeople, rather than admitting to their own irresponsible behavior, have shunned stocks altogether as “too risky”.
To many practitioners of the value approach, the term value investing is a redundancy. As Charlie Munger once said, “all sensible investing is value investing”. Regardless of what we call it, value investing represents a sensible and prudent method for investing in common stocks.