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4 Rules of Value Investing

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Buy low, sell high, hold tight, and study hard.

At its most basic, value investing means trying to buy companies that the market has priced below their true worth. Legendary investors such as Benjamin Graham and Warren Buffett have followed this approach to great success. Let’s review four key concepts that drive value investing, and explore how they can help you make better investments.

  1. Margin of Safety

Value investing isn’t just about buying low-priced stocks; it’s about finding good stocks at a fair price. The “margin of safety” is the gap between where the market has set a company’s price, and what you believe that company’s really worth – its intrinsic value. If you’re right, then sooner or later the market will recognize the company’s true value, and you’ll profit from the resulting increase in its price.

This concept makes market downturns the best time to buy good stocks. If the stock market is unfairly punishing good companies alongside bad ones, you have an even better chance to scoop up the good ones at a discount to intrinsic value. Unfortunately, most investors do the opposite, buying more stocks when the market is high and investors are cheerful. In these circumstances, sometimes even great companies can trade for more than they really merit, setting you up for at least short-term losses when their prices slide back down into reasonable territory.

Buying with a margin of safety is easier said than done. Powerful psychological forces drive us to follow the crowd, buying in when the market is up and selling out when it’s down. To swim against that current, you’ll need to cultivate a rational mind and a lot of self-discipline.

  1. The existence of “Mr. Market”

Benjamin Graham invented “Mr. Market” to personify the stock market’s shifting moods. In Graham’s idea, Mr. Market comes to your door every day, offering to buy stocks from you or sell them to you. But he’s a very emotional guy, and very sensitive to market information.

When Mr. Market gets happy and excited, he can also get arrogant and refuse to trade with you. There are plenty of other people waiting to trade with him, and that high demand means they’re willing to pay him more than you are for the same stocks. Why should he bother with you? When Mr. Market grows this overconfident, you’re better off leaving him alone.

But sometimes, Mr. Market can get down and depressed. No one wants to trade with him, so he’ll offer you great bargains in his desperation to close a deal. According to Graham’s theories of value investing, these are the best times to buy from Mr. Market.

  1. Long-term investing

The real risk in equity investment lies not with the investment itself, but with the investor. After all, different people can get very different results from the same company.

Suppose Investor A and Investor B buy the same stock at the same time. Investor A grows impatient after one month, with the stock down 15%, and decides to sell and cut his losses. But Investor B doesn’t worry about short-term ups and downs. She holds on for months, even years, and watches that 15% loss slowly grow into a 100% gain.

Warren Buffett has suggested that if you’re not willing to own a stock for 10 years, you shouldn’t own it for even 10 minutes. Value investors trust that the market may be wrong in the short term, but will always be right in the long term. And they’re willing to stay patient and hold stocks until the market proves them correct.

  1. Invest in stocks that you understand very well

You can’t know a company’s intrinsic value just by looking at it. To truly decide whether a stock’s current price is fair, you need to research the company behind it. That means studying the company’s potential growth rate, its product and service quality, its senior management’s ability and integrity, and much more. And since value investors base their buying and selling decisions on their calculations of intrinsic value, the best of them never buy any company they don’t thoroughly understand.

Value investing isn’t the only successful style in the market. Dividend investors seek companies with steady, sturdy payouts that will grow over time. Growth investors are willing to take risks on companies that may trade above their intrinsic value, in the belief that the market is actually underestimating those businesses’ future prospects.

But in my opinion, value investing is the most feasible way to enjoy a reasonable return on our investments, while still protecting our capital, regardless of market sentiment. When other investors get aggressive, value investors play defense. It may not be the most glamorous approach to investing, or win you the best bragging rights, but I think it’s an intelligent path to real stock-market success.

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Disclosure: Johnny Chan does not own shares of any companies mentioned. Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance.