8 Key Rules of Value Investing That You Must Know (2024)

8 Key Rules of Value Investing That You Must Know (1)

Value Investing as a concept was introduced in the 1920s by Benjamin Graham and David Dodd. Over the years, the original value investing techniques have been adjusted and improved by renowned investors like Warren Buffet, Charlie Munger, Dr. Michael Burry, Seth Klarman, and Joel Greenblatt.

While all the renowned investors mentioned above have engaged in value investing, one might wonder what value investing actually is. Well, value investing is defined as an investment approach in which investors seek out stocks of companies that are trading at a discount. This means that the current market value of the stock is lower than its underlying value.

However, in recent years, the true nature of value investing has been diluted and misinterpreted. This has led many investors to consider buying cheap stocks in out-of-fashion industries as value investing. Unfortunately, this is not the correct way to seek out value investments.

Value Investing - 8 Rules followed by Great Value Investors like Warren Buffett | ETMONEY

Fortunately, value investing practitioners have put together certain rules that form the bedrock of this investment approach. In this blog, we will discuss 8 key rules of value investing you must know.

1. Be Calculative, Not Speculative When Selecting Investments

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham.

Benjamin Graham, often considered as the father of value investing, wrote the above in his classic book, “The Intelligent Investor.” There are two key lessons that you can draw from the above statement:

a) Value investing must be done intelligently, i.e., it must be supported by detailed research and analysis.

b) The focus of value investing is to avoid capital losses and generate adequate returns instead of attempting to pick high-risk investments with a low probability of generating returns.

Based on these features, value investing is qualitative, calculative, and even predictive to some extent, but it is definitely not speculative.

2. Know The Intrinsic Value Of The Investment

Most investors buy and sell investments on the basis of stock price movements. But, value investors typically believe that the price of a stock generally matches its underlying value, i.e., its intrinsic value over the long term.

So, if a stock is currently priced at lower than its intrinsic value, then there is a case for buying the stock at this discounted price. Now, there are various ways in which the intrinsic value of a stock can be estimated.

Some value investors use a simple price-to-earnings (P/E ratio), which explains the price an investor needs to pay for each rupee of profit. Other methods of calculating the intrinsic value of stocks include the use of relative measures like the P/E ratio of a company versus the industry.

Investors can also use more refined models to estimate the intrinsic value of a stock. These include using PEG (Price/Earnings to Growth) ratios, enterprise value to EBITDA (earnings before interest, taxes, depreciation, and amortization), the discounted cash flow method, the replacement cost approach, the sum of the parts methodology, etc.

Even though there are multiple ways to determine the intrinsic value of a stock, a value investor never makes a decision based solely on the market price of a stock. Instead, determining the intrinsic value of a stock is a primary requirement for any value investor.

3. Ensure A High Margin Of Safety

The difference between the current market price and the intrinsic value of a stock is called its “margin of safety.” For example, if a stock is currently trading at Rs. 100 and its intrinsic value is Rs. 95, then the margin of safety for the stock is 5%.

As discussed earlier, the intrinsic value of a stock is calculated using various data such as historical information about the company, competitors, industry, etc. This calculation also uses some key assumptions regarding the company’s future, which might be incorrect and lead to errors. Therefore, having a high margin of safety gives an added cushion or safety net to the investor.

Most value investors seek a margin of safety ranging from 30 to 60% when selecting investments. This means that the margin of safety also represents the potential upside for the asset if the intrinsic value calculations are correct.

4. Focus On Making Long-Term Investments

It can sometimes take some time for a company’s share price to match its intrinsic value. This can occur due to the state of the economy, because the investment belongs to an out of favor sector, etc.

As it can take many years for the market value of a stock to match its intrinsic value, value investing requires practitioners to be patient and wait. By waiting, value investors give markets sufficient time to recognize the actual value of the company’s stock. But being patient and waiting can be pretty difficult as we are constantly bombarded with the latest updates and trends from around the world.

But patience is the key to achieving success as a value investor. The legendary investor Warren Buffett, a student of Benjamin Graham, once said – “The stock market is nothing short of a device that transfers money from the impatient to the patient.

So, value investors should take this investment lesson from Warren Buffett to hear and learn to be patient.

5. Do Not Follow The Herd

If an investor prefers to go with the flow, or practices momentum investing, then value investing might not be the best fit for you. This is primarily because stocks become undervalued when investors are looking elsewhere, and this has historically occurred many times.

For example, in 2020, the energy, technology, and pharma sectors emerged as the most popular sectors to invest in. But these were the most ignored sectors multiple times between the 2015 to 2019 period.

So, a good value investor must have the ability to ignore the noise. This way, one can go against the momentum and the conventional wisdom to seek out investments that no one else is looking at.

Taking such a contrarian stance might even look foolish at times. But to succeed as a value investor, having confidence in one’s investment choices is more important than the fear of looking foolish. So, while not everyone can have a contrarian mindset, it is an essential trait for a value investor.

6. Select Investments That Avoid Loss

Legendary investors Benjamin Graham and David Dodd published their book “Security Analysis” in 1934. At that time, the United States was still recovering from the Great Depression of the 1930s. During this period, 1 out of 4 workers had lost their jobs, over 4000 banks had failed, and the stock markets had lost almost 90% of their value.

In “Security Analysis,” Graham and Dodd put forward a cardinal rule of value investing – avoid losses. This is often considered one of the most basic value investment lessons from Benjamin Graham, and the mathematical basis for this is pretty simple.

For example, if the value of an investor’s portfolio decreased by 30% and then posted gains of 30%, the investor has actually not reached the break-even point. The value of investments is now 9% lower than the amount that was initially invested. So, to recover the lost capital, the investor now has to generate higher returns.

But, seeking higher returns from investments usually means taking higher risks, which, can lead to even higher losses. This is the complex cycle of returns and risk that investors often find themselves in when they lose money in the stock market.

Successful value investors minimize the risk of big losses by keeping a large margin of safety instead of chasing speculative opportunities. This can be achieved by focusing on just a few sectors and businesses that they actually understand.

Even though this might not always result in market-beating growth, avoiding losses puts value investors in a better position to achieve high risk-adjusted returns.

7. Know The Reason For Selecting Investments

Value investing is not a passive investment strategy. Instead, stock selection is a critical feature that distinguishes value investing from other investment styles.

A successful value investor has in-depth knowledge of his investments and must be able to answer some critical questions about his investment choices, such as:

  • What does the company do?
  • Who are the competitors?
  • What is the company’s competitive advantage?
  • Which valuation model is the best fit for the stock?
  • Why is the stock selling at a discount? And so on.

But beyond knowing these details, it is also crucial for a value investor to stay updated on any recent developments that are affecting the company.

This can be done by reading and understanding the company’s financial statements, participating in quarterly analyst calls, meeting with the firm’s management, and interviewing past employees. Additionally, one also needs to get the perspective of other stakeholders like competitors, suppliers, and customers to get a clear picture of the company’s prospects.

Unfortunately, a majority of investors don’t do this and that is one of the key reasons why value investing and its practitioners form a very small part of the investing population.

8. Understand The Market Dynamics Before Investing

Value investing requires investors to respect the market dynamics and make investment decisions when conditions are favorable. In his book, The Intelligent Investor, Benjamin Graham describes this by using an imaginary character, Mr. Market. This fictional investor’s behavior is driven by different feelings of panic and euphoria.

When Mr. Market is in a very optimistic mood, he quotes a high stock price. But when he is in a less optimistic or pessimistic mood, he is willing to accept a lower price. Graham uses this example to advise readers that while Mr. Market’s behavior is quite mercurial, it is ultimately up to the investor to decide whether to actually make an investment or hold off.

So, value investors make investment decisions only when they deem the market conditions to be favorable. Value investors should thus be prepared to hold on to their cash and not make any investments when there are no viable opportunities.

Bottom Line

In our view, as value investing requires picking investments in a calculated fashion, a successful value investor can never follow a herd mentality. It is also necessary for value investors to be patient, not engage in speculation, and have deep knowledge about their investment choices to succeed. It is rare to come across this combination, so a very small number of investors actually engage in value investing.

As an enthusiast deeply entrenched in the world of investment and finance, particularly in the realm of value investing, I bring forth a wealth of knowledge and experience garnered from years of dedicated study and practical application. My insights stem from a comprehensive understanding of the principles laid down by luminaries such as Benjamin Graham, David Dodd, Warren Buffett, and other renowned investors who have shaped the landscape of value investing.

Value investing, as a concept, traces its origins back to the seminal work of Benjamin Graham and David Dodd in the 1920s. Through meticulous research and analysis, these pioneers established the foundation upon which modern value investing principles are built. Over the decades, the discipline has evolved and been refined by stalwarts like Warren Buffett, Charlie Munger, and Seth Klarman, among others, each contributing their unique perspectives and strategies to the craft.

The essence of value investing lies in the astute identification of stocks trading at a discount to their intrinsic value. This fundamental approach prioritizes thorough analysis and reasoned decision-making over speculative fervor. Let's delve into the core concepts articulated in the article you provided:

  1. Be Calculative, Not Speculative: Benjamin Graham emphasized the importance of intelligent investing, grounded in thorough analysis and a focus on capital preservation. Value investing demands prudence and diligence in stock selection.

  2. Know The Intrinsic Value Of The Investment: Value investors ascertain the intrinsic value of a stock, employing various methodologies such as price-to-earnings ratios, discounted cash flow models, and comparative analysis to gauge its true worth.

  3. Ensure A High Margin Of Safety: The margin of safety, the buffer between a stock's market price and its intrinsic value, safeguards investors against unforeseen risks and inaccuracies in valuation.

  4. Focus On Making Long-Term Investments: Value investing advocates patience and a long-term perspective, allowing time for market prices to converge with intrinsic values.

  5. Do Not Follow The Herd: Contrarianism is a hallmark of value investing, as practitioners eschew herd mentality in favor of uncovering undervalued opportunities overlooked by the majority.

  6. Select Investments That Avoid Loss: Preservation of capital is paramount in value investing, with an emphasis on minimizing downside risk through prudent portfolio construction and sector understanding.

  7. Know The Reason For Selecting Investments: Value investors possess intimate knowledge of their investments, backed by comprehensive research and a deep understanding of company fundamentals.

  8. Understand The Market Dynamics Before Investing: Value investors navigate market dynamics judiciously, recognizing opportune moments to deploy capital and exercising restraint during periods of exuberance or uncertainty.

In conclusion, value investing demands discipline, discernment, and a steadfast commitment to fundamental principles. By adhering to the tenets espoused by its pioneering figures and embracing a contrarian mindset, investors can unlock the potential for long-term wealth creation in the dynamic world of finance.

8 Key Rules of Value Investing That You Must Know (2024)
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