Q: What is Value Investing and why Warren Buffett has been following it for his life long stock investment?
A: Value Investing, a rational equity investment framework pioneered by Ben Graham in the 1930’s and later on flourished primarily by Warren Buffett and Peter Lynch, is still the most respected and validated equity investment guidepost in the world, albeit few equity investors truly followed it.
In a nutshell, Value Investing is based on the central theme to maximize the Expected Reward/Risk ratio of a stock investment decision. There have been ample evidences and research results demonstrating that over the longer term, stock prices tend to correlate closely with the EPS (Earning per Share) growth rates of a company.
As only high quality companies with significant entry barriers (wide moats per Warren Buffett) are likely to sustain their earning powers, so Value Investors naturally look for high quality companies that are more assured of their sustained earning potentials. Also, if a high quality company is still in its early growth stage, then its earning growths will be phenomenal for the next 5-10 years. Peter Lynch has been famous for his great success in spotting early growth high quality companies before the mainstream market eventually caught on.
By concentrating on high quality company stocks, figuring out their sustained earning powers and growth rates, then their fair market prices, or Intrinsic Values, as defined by Ben Graham, can be grossly determined. In order to further increase the desired Expected Reward/Risk ratio, a savvy Value Investor would only buy a high quality company stock at a significant discount (30-50% typical) from its Intrinsic Value, which is the essence of the “Margin of Safety” concept stipulated by Ben Graham.
The bigger the Margin of Safety, the higher the Expected Reward/Risk Ratio, and this is the Holy Grail for Value Investing. However, the higher the Margin of Safety desired, the harder it is to find such opportunities afforded by the stock market. This is the reason why Buffett always reminds value investors to be patient to wait for the “Fat Pitch” to come like a baseball player. In general, great opportunities to invest in high quality Large/Mid-Cap companies only occur when the market is extremely pessimistic, thus Buffett’s famous quote “Be greedy when others are panic” elegantly applies here.
Nevertheless, the market is always full of good opportunities for savvy value investors to spot tomorrow’s Large/Mid-Cap companies today among those promising Small/Micro-Cap companies which have the strong potential to disrupt the industries or sectors they are in. Possessing a VC-like professional due diligence caliber is the key to success in this “Buy growth, but don’t pay for it” (per Martin Whitman) hidden gems discovery scenario, as well demonstrated by Peter Lynch during his 17-year Magellan Fund tenure which recorded a phenomenal 29% annualized return rate.
In recent years, academic researches have pointed out that the performance of Value Investing can be further enhanced by the “Momentum Life Cycles” framework developed by Professor Charles Lee of Stanford University and enhanced by Professor Ron Bird of University of Technology, Sydney. Also, recently retired Professor Robert Haugen of UC-Irvine had engaged in an extensive stock market regression analysis over a span of 35 years indicating that employing valid stock momentum indicators can further enhance the performance of a pure Value Investing strategy. A thorough understanding of the “Momentum Life Cycles” framework requires a reasonable caliber in both the Business Model Analysis and Technical Analysis domain, beyond the Accounting-flavored Fundamental Analysis skills possessed by most savvy Value Investors.