Value Investing: A Primer For The Layman Stock Investor
By Allen Fontana
Value investing can be defined as an investment method developed by Benjamin Graham and David Dodd who coauthored the book, "Security Analysis." Graham subsequently published, "The Intelligent Investor," for the lay person. Value investing takes on many forms but can be defined as buying companies whose shares are deemed to be underpriced using some form of fundamental analysis. Fundamental analysis is the method of using real data such as financial conditions and management of a company to measure the security's intrinsic value. Fundamental analysis is sometimes considered the opposite of technical analysis. Technical analysis is the study of how a security's price behaves and how to use this behavior to make a profit and avoid losses. Think of fundamental analysis as the tool used by investors while technical analysis is the tool used by traders. Of course the delineation is not that black and white and prudent investors or traders use both methods.
Fundamental analysis uses the company's real data to measure the security's intrinsic value. This value is what the investor uses to compare with the security's current market price. Is it underpriced, overpriced or selling at fair value? The difference between the security's intrinsic value and the market price is sometimes called the margin of safety. Graham and Dodd came up with the term "margin of safety" in their book,"Security Analysis." Margin of safety is defined as the difference between intrinsic value and the purchase price of the stock. This difference protects the investor from poor buying decisions and downturns in the general market. Warren Buffet who many consider to be Grahams greatest student calls this term the moat. Buffet subscribes to a very simple value investment philosophy in which he applies two rules. Number one is "don't lose money." and number two is, "don't forget the first rule." Avoiding loss is key to the value philosophy. Investigate before you invest.
All companies have an intrinsic value which is based on its real current value in the event of being purchased by a competitor or a merger. In the long-term, stock prices will reflect this value, but in the short and medium term, market prices can be above or below it. Value investors seek to make the most profit from this difference. Many subscribers to the margin of safety theory advise only purchasing the security when its intrinsic value is 40% to 50% above market price. That is your margin of safety. This margin secures the investment against a permanent loss of capital even though short-term adverse market movements may occur.
Graham used a now famous parable to explain his value philosophy, The Parable of Mr. Market. Stock prices go up and down significantly in value. For a true value investor, the only significant meaning of price fluctuations is that they offer "... an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal." The actual parable can be found in Graham's book, "The Intelligent Investor," chapter 8, The Investor and Market Fluctuations. In a nutshell Graham uses the parable to suggest the attitude an investor should adopt toward fluctuations in prices. Imagine owning a $10000 interest in a company along with a partner, Mr. Market. Every day Mr. Market offers either to buy your interest or to sell you a larger interest. Sometimes his offer is extremely high, allowing you a good opportunity to sell. At other times Mr. Market's price is very low, allowing you a good opportunity to buy. Still at other times, his price quotes are justified by the intrinsic value of the business. Mr. Market is there for your convenience and profit. Mr. Market's price is often wrong and bears no relationship to underlying conditions and values. Graham argues that it is a mistake to let Mr. Market determine what the stock is worth. Form your own independent stock valuation based on real facts and the exploit the difference between those valuations and Mr. Market's price.
For further readings on Value Investing I recommend, "The Intelligent Investor" by Benjamin Graham and "Security Analysis" by Benjamin Graham and David Dodd. Also any annual report issued by Berkshire Hathaway will provide the reader with a wealth of real world common sense value investing. There are also a number of free investment magazines to subscribe to that offer real value and insight. This author recommends Profit Confidential by Lombardi Publishing for proven investment and stock market advice.
Allen Fontana is a freelance writer and blogger on topics such as investing in the stock market, value stocks, life insurance and travel. For more articles on investing and stocks check out Allen's Blog right here [http://www.topstockpick.info].
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