Value Investing - A Return to Common Sense

To begin to understand the attraction many investors have with value investing, it is helpful to look back on what factors brought it about. For certain, as long as there have been things to invest in, people have searched for the diamond in the rough, but value investing really gained prominence due to the work of two individuals: Benjamin Graham and Warren Buffett.

Benjamin Graham

If living through the Great Depression teaches you one thing, it is how to recognize value when you see it. Benjamin Graham started a New York investment firm called Graham-Newman with little formal training, and he achieved great success through some of the most turbulent times in the world of finance. He enshrined the ideals of the era in two books, Security Analysis and The Intelligent Investor, which promoted the principles of value investing to the masses. He eventually moved on to teach his ideals at Columbia University, passing his knowledge along to many bright students, one of which was Warren Buffett.

Warren Buffett

If there was a celebrity of value investing, it would Warren Buffett. But the celebrity status is not undeserved. Mr. Buffett has earned it through consistency, profitability, and a unmatched sense of value. After studying under Mr. Graham, Buffett eventually started working for Graham's company, Graham-Newman. There he learned how to manage large portfolios and use insurance company assets as an investment tool. Buffett later pooled together some money from friend and family and started his own investment fund, Berkshire Hathaway.

He used his first acquisition through stock purchases, Berkshire, as an investment conduit to buy other businesses. How did he know which businesses to buy? He applied Graham's principles of looking at financial statements and his own intuition about the intrinsic value of the company to locate stocks selling well below what they were truly worth. He bought a company based on its value, not whether its stock was on an upward trend or the financial analyst on the cable news station said that sector of the market was ripe for growth.

It seems history does repeat itself and again we find ourselves in a market situation where value trumps everything. You can't just trade shares and make money. Investing takes research, patience, and strategic action.

Compounding Formula
used to calculate the time value of money

Future Value = Present Value x (1 + rate of return) number of years invested

The key to this formula is rate of return and number of years invested. If you increase either, you are going to do exponentially better. But if you have one that is extremely low, you may do poorly even though the other is high. For instance, if you have a high rate of return (or interest rate) but only 1 year to hold the investment, you aren't going to take advantage of the compounding well. Conversely, if you hold the investment for 20 years but have a really low rate of return (think Certificates of Deposit), you may not even beat inflation!

Calculating Rate of Return
often referred to as compounding rate of return or geometric rate of return

Compounding Rate of Return = ((Ending Value / Beginning Value)(1/number of years invested))-1

Because we are working with compounding value, we cannot just take the expected return and divide it by the number of years we expect to hold the investment to get our rate of return. We need a formula that takes into account the reinvestment of the gain over time. The formula above does that.

Buying stocks is an art AND a science. You must apply both sides of your brain to reap a substantial reward. Intuition and Data perform well together, and can make you a lot of money.