Content:
- Companies have intrinsic value
- Always have a margin of safety
- The efficient market hypothesis is wrong
- Diligence and patience are keys to success
Companies have intrinsic value.
(Intrinsic value - The actual value of a security, as opposed to its market price or book value.)
The defining rule for value-investing; if you do not believe in this principle, you can no longer be regarded as a value investor, or even an investor for that matter.
(Intrinsic value - The actual value of a security, as opposed to its market price or book value.)
The defining rule for value-investing; if you do not believe in this principle, you can no longer be regarded as a value investor, or even an investor for that matter.
The company's stock price can change even when the company's intrinsic value is the same. Understanding this, value investors will not be psychologically affected by vast market swings, since they believe in the company's intrinsic value.
Here is a story, a financial one, that I've chanced upon recently - The Tulip Mania. This story probably demonstrates the importance of this rule, because ultimately if the Dutch were to recognize the "intrinsic value" of the tulip, the investing bubble would not have occurred.
Disclaimer: This story has been highly summarized for easier reading and according to my understanding of this story.
Forget about the history of tulip and how it became popular in Europe, just understand that at that time, tulips were highly sought after by wealthy Englishmen. A virus hit the tulip plantations throughout Europe, giving the tulips their mesmerizing color schemes. With this new type of infected tulips, the English were even more dazzled by the tulips' beauty, and the tulip became even more popular.
The virus retarded the tulips' growth, making it even harder to increase the supply of these exotic tulips. By 1634, the beauty of these tulips became widespread across Europe. Even the lowest members of society were after these tulips! Due to its limited supply and increasing demand for it, the prices of tulip soared exponentially.
The demand for rare tulips increased so much in 1636, that they were traded on Amsterdam's Stock Exchange and in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns. For the first time, symptoms of gambling became apparent too. Stockbrokers, ever alert for a new speculation, dealt largely in tulips. They used every trick in the book to produce price fluctuations.
At first, as with all gambling mania, confidence was high - everybody gained. The tulip-brokers speculated in the rise and fall of tulip stocks. They made large profits, buying when prices fell, and selling when they rose.
Many individuals suddenly grew rich. People now rushed to trade in tulips. Everyone imagined that the passion for tulips would last for eternity. They believed that wealthy people from across the globe would travel to Holland, and pay ridiculously high prices for these tulips. In fact, many Europeans, including the midde-class citizens, were selling their assets like houses and luxuries just to get their hands on this "limited commodity".
Now, would you trade a house for these tulips???
Finally, there comes a point where the "smart" ones began to see the madness of this tulip trade. They have come to realize that the price of tulips cannot go higher. With this in mind, the wealthy ones no longer bought the flowers for their gardens, but to sell them in order to lock in their profits. The sale of tulips started off slowly, then evolved into a panic-stricken rush.
At the end of the tulip mania, many find themselves stuck with these "beautiful tulips", as there is no longer any demand for them, and for all that they have sacrificed - their homes, their wealth, their luxuries, this is truly a catastrophic moment for many Europeans.
This story reinforces two ideas:
Here is a story, a financial one, that I've chanced upon recently - The Tulip Mania. This story probably demonstrates the importance of this rule, because ultimately if the Dutch were to recognize the "intrinsic value" of the tulip, the investing bubble would not have occurred.
Disclaimer: This story has been highly summarized for easier reading and according to my understanding of this story.
Forget about the history of tulip and how it became popular in Europe, just understand that at that time, tulips were highly sought after by wealthy Englishmen. A virus hit the tulip plantations throughout Europe, giving the tulips their mesmerizing color schemes. With this new type of infected tulips, the English were even more dazzled by the tulips' beauty, and the tulip became even more popular.
The virus retarded the tulips' growth, making it even harder to increase the supply of these exotic tulips. By 1634, the beauty of these tulips became widespread across Europe. Even the lowest members of society were after these tulips! Due to its limited supply and increasing demand for it, the prices of tulip soared exponentially.
The demand for rare tulips increased so much in 1636, that they were traded on Amsterdam's Stock Exchange and in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns. For the first time, symptoms of gambling became apparent too. Stockbrokers, ever alert for a new speculation, dealt largely in tulips. They used every trick in the book to produce price fluctuations.
At first, as with all gambling mania, confidence was high - everybody gained. The tulip-brokers speculated in the rise and fall of tulip stocks. They made large profits, buying when prices fell, and selling when they rose.
Many individuals suddenly grew rich. People now rushed to trade in tulips. Everyone imagined that the passion for tulips would last for eternity. They believed that wealthy people from across the globe would travel to Holland, and pay ridiculously high prices for these tulips. In fact, many Europeans, including the midde-class citizens, were selling their assets like houses and luxuries just to get their hands on this "limited commodity".
Now, would you trade a house for these tulips???
Finally, there comes a point where the "smart" ones began to see the madness of this tulip trade. They have come to realize that the price of tulips cannot go higher. With this in mind, the wealthy ones no longer bought the flowers for their gardens, but to sell them in order to lock in their profits. The sale of tulips started off slowly, then evolved into a panic-stricken rush.
At the end of the tulip mania, many find themselves stuck with these "beautiful tulips", as there is no longer any demand for them, and for all that they have sacrificed - their homes, their wealth, their luxuries, this is truly a catastrophic moment for many Europeans.
This story reinforces two ideas:
- Always invest according to a company's intrinsic value
- Do not simply jump onto the bandwagon! (remember the bandwagon effect in the earlier post?)
Always have a margin of safety
Because if you do so, you not only maximize your profits when the price of the stock rises, you also reduce your loss when the price of the stock falls.
It's really simple. Assuming you are looking at a stock of a shoes company, you have done your work and came up with its intrinsic value of $10. (In later posts, I will be discussing on how to calculate this.) You would want to wait till its price drops to, let's say, $5. If you successfully get your hands on this stock for $5, you would have provided yourself a margin of safety.
If the price of the stock falls to $3, you would lose only $2 whereas if you had bought the stock at its intrinsic value, you would lose $7! However, if the price of the stock rises to $13, you would gain $8 whereas if you had bought the stock at its intrinsic value, you would only gain $3.
Remember him?
Benjamin Graham, the father of value investing,
only bought stocks when they were priced at two-thirds or less of their
intrinsic value. This was the margin of safety that he felt was necessary to
earn the best returns while minimizing investment downside.
The efficient market hypothesis is wrong.
The efficient market hypothesis is wrong.
I hope this point no longer needs to be explained. The fact that stocks CAN be under- or over-valued is sufficient to prove this point.
Diligence and patience are keys to success
As cliche as it may sound, this is 100% applicable to investment in general, not just for value-investing.
And for goodness sake, you reap what you sow! If you don't do your homework and thoroughly analyse the company's fundamentals, you are doomed to failure. Simply relying on broker's advice to pick your stocks won't do you good. Do you really think the brokers are there to help you? If the broker realize that the price of the stock is going to rise, he is going to quit his job, draw out his entire savings, and dump them into this stock! Do you think he would simply let others know of such valuable information?
Also, sometimes you'll decide that you want to invest in a particular company because its fundamentals are secure, but you'll have to wait till the price of the stock falls until it hits a discounted price. It may take another 5 to 10 years for that to happen, but rest assured, you will be greatly rewarded for your patience.
When you hold a stock, patience also plays a key role. Do not sell your stock simply because the market shows bearish trend! (Again, the bandwagon effect!) Wait for market reversals, it may take 10 years or even more than that, but once again, rewards will be handsome.
Note: There are circumstances where investors are forced to sell their stocks regardless of their will. They need immediate cash to pay for the cost of living, clear their debts etc. As such, I would honestly recommend investment only to those that are rich, because after all, the prospect of losing their investment would not be as devastating to them as that to those who are less well-off. Those who have less capital with them will find themselves succumbing more often to their emotional fear, which is a path to failure in investment (needs verification, but this is my hypothesis based on my observations. Do keep this in mind though).
Conclusion:
We have established the golden rules of value investment. Some of these rules are even applicable to investment in general (There are more rules to abide by in general investment, and I may be exploring them some time later). Do not take these rules lightly; after all, many investors fail simply because they have forgotten these rules.
In subsequent posts, I will be discussing on technical concepts pertaining to analyzing a company's fundamentals, as well as establishing the risks involved in value investment specifically.
Thank you and have a great day ahead.
Acknowledgements:
http://www.businessweek.com/2000/00_17/b3678084.htm
http://winninginvestor.quickanddirtytips.com/what-are-the-differences-between-investing-and-trading.aspx
http://www.thetulipomania.com/
www.investopedia.com
Jan Arps (n.d.). The Complete Idiot's Guide to Technical Analysis.
And for goodness sake, you reap what you sow! If you don't do your homework and thoroughly analyse the company's fundamentals, you are doomed to failure. Simply relying on broker's advice to pick your stocks won't do you good. Do you really think the brokers are there to help you? If the broker realize that the price of the stock is going to rise, he is going to quit his job, draw out his entire savings, and dump them into this stock! Do you think he would simply let others know of such valuable information?
Also, sometimes you'll decide that you want to invest in a particular company because its fundamentals are secure, but you'll have to wait till the price of the stock falls until it hits a discounted price. It may take another 5 to 10 years for that to happen, but rest assured, you will be greatly rewarded for your patience.
When you hold a stock, patience also plays a key role. Do not sell your stock simply because the market shows bearish trend! (Again, the bandwagon effect!) Wait for market reversals, it may take 10 years or even more than that, but once again, rewards will be handsome.
Note: There are circumstances where investors are forced to sell their stocks regardless of their will. They need immediate cash to pay for the cost of living, clear their debts etc. As such, I would honestly recommend investment only to those that are rich, because after all, the prospect of losing their investment would not be as devastating to them as that to those who are less well-off. Those who have less capital with them will find themselves succumbing more often to their emotional fear, which is a path to failure in investment (needs verification, but this is my hypothesis based on my observations. Do keep this in mind though).
Conclusion:
We have established the golden rules of value investment. Some of these rules are even applicable to investment in general (There are more rules to abide by in general investment, and I may be exploring them some time later). Do not take these rules lightly; after all, many investors fail simply because they have forgotten these rules.
In subsequent posts, I will be discussing on technical concepts pertaining to analyzing a company's fundamentals, as well as establishing the risks involved in value investment specifically.
Thank you and have a great day ahead.
Acknowledgements:
http://www.businessweek.com/2000/00_17/b3678084.htm
http://winninginvestor.quickanddirtytips.com/what-are-the-differences-between-investing-and-trading.aspx
http://www.thetulipomania.com/
www.investopedia.com
Jan Arps (n.d.). The Complete Idiot's Guide to Technical Analysis.
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