Benjamin Graham, the father of Value Investing, and Warren Buffett's mentor, extended this concept to the stock market by illustrating the following parable. From Intelligent Investor:
Imagine that in some private enterprise you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very indeed very obliging. Every day he tells you what he thinks your share ownership is worth and furthermore offers either to purchase you out or sell you an additional share of ownership on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his euphoria or his pessimism run away with him, and the value he offers seems to you a little short of silly.
If you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily communication determine your view of the value of your share ownership in the business. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But at the rest of the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."
Put another way, one must distinguish "quotational loss" versus "permanent loss of capital". The former is movement in the price of a stock due to psychological sentiment, liquidity issues or other factors. The latter is a "permanent damage" to the franchise of the business due to fundamental factors - such as product obsolescence, permanent changes in market demand for a product, losing market share to a better competitor, changes in the habits of customers, upcoming product substitutes.
This all sounds simple. But it begs the question: How does one know if the value of a business is changing? The answer is not to look at the stock price, but to do your own research. For example - try the product, visit the store, read business and trade magazines, or ask friends who are customers of the business. An alternative is to do research on the internet and gather facts and data points about the business.
With the internet, fundamental research on stocks has never been as widely available and convenient as before. You can go directly to the company's SEC Filing, pick up a chart, news headlines, get analyst's estimates and ratings, earnings history, financial statements and many more. You can also do market research on government web sites and other trade association web sites. Finally, if you have the time, you can participate in many active communities and discuss with others about a product, a stock, etc.
Value investors search the marker for the undervalued companies. The reason a company is thought to be undervalued is because value investors believe that the stock market overreacts to good and bad news announced by companies in the company's monthly, quarterly or annual reports. This means that in the short run share prices fluctuations have more volatility than that of the average long run price of the shares in a company. The short term swings in the price of shares leaves value investors with a good opportunity to make a quick buck.
The majority of value investors seek out stocks with lower prices than the average price to book. However the value of stocks is no longer as easy to estimate as it once was. The book value of certain goods is well defined however since the advent of fast paced technological advancement and the constant changing of technological products the value of most goods is no longer so easy to predict.
The potential in value investing was first recognised by Benjamin Graham who was a lecturer from Columbia University. What Graham propagated was a cautionary approach to investing. What this means is, purchasing stocks that are relatively safe in that they don't fluctuate greatly from their book value. This protects value investors from any potential stock market shocks in the future be they good or bad.
Value investing is the a good relatively safe way for an experienced investor to make safe earnings on the stock market while minimizing risk. The fluctuations of the stock market are avoided as opposed to day traders who like the ride the waves of the stock market. Day trading is a very risky form of investment and not for the faint hearted investors.
The stock market has just as many losers as winners. For every stock sold on the market by a seller there is a buyer out there who is purchasing it. Only one of you, either the buyer or seller can be right. One of you is making a profit the other one is making a loss.
In summary - in order to be a good value investor you must have a deep understanding of the how the market works and a keen eye for how efficient the market is at any given point of time.
Both Maria Suarez & Mike Singh are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
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