In theory: Value investing from the masters

Part 1 of a series of 4 articles on beginning value investing, originally published in the gleaming new-look Interactive Investor mothership’s Trading and Investing Strategies pages. If you’re new to value investing, or a seasoned bargain hunter, I’d like to know whether you think I’ve done a good job explaining the basics.

You’ve probably heard of some of the great value investors. Most famous of all is Warren Buffett, who tends to swap places every so often with his friend, software billionaire Bill Gates, as the world’s richest man.

Buffett is no longer an investor like you, or I. His company, Berkshire Hathaway (BRK.A), is one of America’s largest and as well as being a major shareholder in giants like Coca-Cola (KO) and American Express (AXP), it owns numerous companies outright; insurance companies, a railroad and a sweet manufacturer, for example.

Even though he’s as much a businessman as an investor, or perhaps because he’s a businessman, Buffett still adheres to many of the value investing principles he learned as an apprentice in the 1950s.

As for pure investors, it’s a mildly embarrassing fact for the fund management industry that few of its members beat the market consistently over a long period of time. Coincidentally two that did, worked for the same company, both of them value investors. Peter Lynch who ran Fidelity Magellan is perhaps America’s most famous former fund manager, and Anthony Bolton who ran Fidelity Special Situations is perhaps Britain’s most famous.

There are many other examples of successful value investors, but the important point about them is they share a common philosophy. That is, when you invest you become part-owner of a business, and the success of that investment depends on two things; the price you pay and how well the business does in future.

You can see the value principle at work in the TV programme Dragon’s Den. A successful pitch always plays out the same way. The dragons ask the entrepreneur about their business: how it makes money, how it’s funded at the moment, and how it’s performing – the value of sales and profits in recent years and maybe some forecasts.

If a dragon understands the business, and they’re satisfied it will earn enough profit to give them a good return on his investment, they’ll make the entrepreneur an offer. Almost always they’ll demand a bigger share of the company than the entrepreneur wants to part with because the company may not do as well as the entrepreneur thinks and if it doesn’t, the dragon’s share of the profits, their return, will be lower.

By demanding a bigger share of the company for the same amount of money, the dragon’s are trying to pay less than they think the companies are truly worth. You might think that’s tight-fisted, but actually it’s a form of insurance. Since a company’s value depends upon how much money it earns in the future, which nobody can know for sure, an investor must pay less than their estimate of a fair price, to be confident they’ll get their return.

The difference between a fair price, and the price an investor pays, is, in value investing terms, known as the ‘margin of safety’ although, since safety is elusive in investing, I prefer to think of it as a margin of error in valuation. The bigger the margin of safety (or error), the more profitable an investment is likely to be.

This principle was first articulated by perhaps the most significant value investor of all, Benjamin Graham. He was a hedge fund manager who made a fortune in the Roaring Twenties, lost it in the Wall Street Crash, and regained it during the depression years. Graham was a professor of finance and he literally wrote the textbook on investment analysis. The first edition of Security Analysis was published in 1934, and it’s still in print today.

Warren Buffett trained at Graham’s firm, and though he, Lynch, Bolton and countless other investors have embellished Graham’s methods, the one thing that unites them all is a refusal to pay more than they think a business is worth, hence their reputations as value investors.

Value investing primers:

• The Little Book of Value Investing by Christopher Browne

• One Up on Wall Street by Peter Lynch