According to Warren Buffett, “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” While many modern investors and scholars may tell you otherwise, who are we to disagree with undoubtedly the most successful investor in all of history? Buffett, to this day, remains involved in some of the biggest investment plays in the world, and he isn’t shy to discuss his tactics.
If you are at all familiar with the investment genius, and business magnate – Warren Buffet, then chances are you’re also familiar with his basic investment principles and philosophies. Just in case you’re not, let’s Buffett is a strong believer in value investing – an investment paradigm that derives from the ideas on investment that Ben Graham and David Dodd began teaching at Columbia Business School in 1928.
Although value investing has taken many forms since its original conception, the foundation remains the same. In essence, value investing involves buying stocks at less than their intrinsic, or fundamental value. There is a lot of calculations involved here, and the intrinsic value is usually calculated through some form of fundamental analysis. To spare you the headache of diving into this even further, allow me to sum up value investing in layman’s terms. Value investing simply means that you buy a security, such as stock in a public company, for a price that greatly underestimates the true value of said company. Buffett himself did just this many, many times over – piling on his billions each time. American Express, Coca-Cola, and Disney are just some of the household names that Buffett was clever enough to spot (and invest in) at the right time.
While the man was obviously on to something with his investment strategies, he did not keep his methods secret; quite the opposite, in fact. In May of 1984, Buffet laid out absolutely everything you need to know about his methods, and investment philosophy. In a speech at Columbia Business School, he introduced what he called, “The Superinvestors of Graham-and-Doddsville.” The speech was later adapted into an essay that you can find here.
In essence, this speech (and essay) challenged the idea that equity markets are efficient through a study of nine successful investment funds generating long-term returns above the market index. There are a lot of great quotes that can be pulled from the essay to effectively summarize it, but the best has to be this:
“The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in that market.” This quote is very powerful, and it summarizes Buffett’s whole approach to investing. He makes it clear that he doesn’t think about buying a stock; he thinks about buying a business.
You might wonder to yourself – if value investing truly works, why isn’t it more wide spread? That’s a fair question, and to be honest, a large part is that what value investors do is not well known or even completely understood. This is mainly due to the fact that universities accept the notion that markets are efficient, and as a result focus more on teaching and applying modern portfolio theory – likely the polar opposite of value investing.
That being said, let’s take a closer look at the value investing process. As originally conceived and developed in the 1930’s by Graham, value investing involved three steps. The first step was to screen stock based on either price-to-earnings (P/E), price-to-book (P/B), or a different valuation related metric. This was done in order to actually identify the possibly undervalued stock. Next, it was important to evaluate the low price-to-earnings stocks to estimate their fundamental value as accurately as possible. The reasoning behind this is very simple. This step was done in order to minimize error, and in turn reduce the risk associated with the investment. When all of that is said and done, an investment decision to buy is made if – and only if – the stock price is below the fundamental value calculated in step two. That being said, there also needs to be some breathing room to play the part of a safety net. This margin – in Warren Buffett’s case – was generally around 30 per cent.
That’s pretty much it. Buffett’s billions are summarized in one short and sweet paragraph. Like many effective success formulas, this one might seem too good to be true. Even so, academic research focused primarily on the first step of value investing found that value stocks outperform growth stocks on a global scale; both when the markets go down, and when they go up. These findings fly in the face of market efficiency, which advocates (rather assertively) that risk and return go together.
If the evidence in favour of value investing is so great, why isn’t everyone a value investor? I can’t answer that, but if I had to make a guess I would say that because the driving forces behind the value premium are human psychology, which at often times can lead to some very irrational choices. It can be hard playing the long game, and greed can often get the better of us.
To summarize Buffett’s philosophy, the following quote – found in his annual letter to the shareholders of Berkshire Hathaway (1996) – says it best.
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”
This really helps paint the big picture. Buffett makes it crystal clear that you don’t have to be a genius to invest well; in fact, all you need to do is master the basics. That being said, if you think you have what it takes to follow in Buffett’s footsteps, go for it. Just make sure you have the patience, not to mention – some serious capital.