If you look at the strategies of most successful investors, it may seem very different from each other. However, most of them credit their success to one simple philosophy: Value investing. Investors like Warren Buffet, Seth Klarman, Joel Greenblat, and countless others follow this philosophy religiously. So what exactly is value investing?
Value Investing is the idea that if you buy a stock at a lower price than its worth, you are getting a good deal and likely to get good returns.
Think of it this way. If you buy a car for Rs 10,00,000 but know it's worth at least 15,00,000, you're getting a good deal, right? Value investors believe that the stock market is filled with deals like these. You just need to know how to calculate a company's worth, buy when it is significantly undervalued, and sell when it is significantly overvalued.
So, how do you calculate how much a business is worth and whether it is under or overvalued? Benjamin Graham, who popularized this philosophy, had a simple yet highly effective way for it. He used to look at stocks that had acceptable fundamentals, were selling at a low Price/Earnings ratio (usually lower than 15 is considered acceptable and lower than 10 is good), and a low book value (usually less than 2 is acceptable and less than 1 is great). His idea was that mediocre or even pathetic companies that are selling for cheaper than their net assets were usually great investments and he was right. Graham averaged a 15% compounded return over his career.
To understand why value investing works, imagine a grocery store that has assets totaling Rs 10 lakhs and liabilities totaling Rs 2 Lakhs. The company, without even considering its earning potential, is worth at least Rs 8 Lakhs. Now imagine that this grocery store is making profits of Rs 1 lakh per year. If the owner came to you and offered that grocery store for 5 Lakhs, would you take it?
It's a great deal and seems ridiculous that such deals exist. However, it happens a lot in the stock market. Until recently, a lot of hydropower companies were selling at this exact position. The ‘market’ believed hydropower companies could only go down even when they were selling at a ridiculously cheap price. Arun Hydropower company, which had earnings of Rs 12.2 per share and a book value of 110, was selling at Rs 94 with the P/E ratio being 7.8 and Book value/share being 0.85. It's selling for Rs 242 right now. Graham would have bought these ridiculously cheap stocks, hold them for a while and sell when the markets realized that they were worth a lot more.
Graham's method is highly rewarding but such opportunities are very rare to come by. In the stock market, undervalued stocks aren't always so obvious and freely available.
Thus, are there other ways to find undervalued stocks? Warren Buffet, perhaps the most successful student of Graham's strategy, followed this exact approach for about 15 years and made huge returns.
However, in the late 1960s, his investment strategy started to evolve from Graham’s teaching. Instead of buying a diversified portfolio of such mediocre or pathetic companies and sell them when they go up, he started to concentrate his portfolios on some great companies he got at a reasonably cheap price and held them for a long time. His associate Charlier Munger helped him refine the original strategy in this way.
In Buffet's own words “ It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. So how did Buffet find whether a company was undervalued? He used something called a ‘discounted cash flow analysis’. Buffet has famously said that “intrinsic value is basically how much cash a business can produce for its shareholders over its lifetime. If you can reasonably predict this and discount it using an appropriate discount rate, that's how much a company is worth. If it's selling at a significantly lower price than this, the stock is undervalued and you should probably buy it”.(Buffet generally likes to buy stocks that are selling for at least 25%lower than their intrinsic value.) This is a daunting task so most value investors, including Warren Buffet, like to invest in ‘boring’ and relatively stable companies where reasonable predictions can be made.
Joel Greenblatt, who made a 29% compounded annual return during his career, bought stocks of companies in special corporate situations like mergers and spin-offs. His idea was these special situations created uncertainty in the future of the companies causing stock prices to go down in the short term. He then identified undervalued companies with a reasonably steady discounted cash flow and invested there. In many cases, the deals of the spin-offs and mergers were so complicated that most people simply didn’t understand what the company was worth. If he could identify such complicated deals and know its shares are significantly undervalued, Greenblatt invested in these companies.
To conclude, value investing means buying a stock at a cheaper price than its real worth. The intrinsic value of a company or its worth can be calculated using some obvious methods like Graham's book value and P/E ratio. However, these situations are rare and can get risky so you are better off holding them with a diversified portfolio. Buffet's discounted cash flow can be generally used to calculate a company's worth but there are a lot of assumptions involved so investing in boring and stable companies is always better. Joel Greenblatt's investing in complicated corporate situations is for experts in the field where very few people understand what the company is worth. There are lots of other ways of identifying undervalued stocks too. However, the key principle is always the same: Never overpay for a stock. No matter how good a company is, if you buy it at an overvalued price, you are making a terrible investment. On the contrary, even if you buy a pathetic company at a significantly undervalued price, you are making a good investment.