Value Investment: what is it?

That's my first post on this blog and i will use it to introduce you to what i think is the investment philosophy that grants an active (or enterprising, as Graham called them) investor the highest chances of success during his investment career.

The value investment thinking school was developed by Benjamin Graham and David Dodd, two professors of Columbia Business Schools and teachers of many famous investors (the most famous of them is Warren E. Buffett, the "Oracle of Omaha"). Benjamin Graham was also a financial analyst and a successful investor: his Graham-Newman Corp. gained an annual compound return of 14.7% from 1936 until he retired in 1956 against a compound return of 12.2% for the US market.

Graham, after surviving the terrible market crash of 1929 (during which the Dow Jones Industrial average index lost almost 90% of it's value) at the expense of painful losses, was inspired to develop a more conservative and safer way to invest. After spending some years developing his new way of investing while teaching at Columbia, Graham finally published the book Security Analysis in 1934 with the aid of David Dodd. This book represents the genesis of fundamental analysis. Graham explains than the market gives too much attention to current earnings and earnings forecasts, which most of the times prove to be unreliable, instead the market should place much more attention on the past performance of the business. To determine a company value the investor should carefully analyse it's past financial statements.
Graham also suggests to the enterprising investor to look for companies that have low market multipliers (like price/earning, price/book value, price/tangible asset value, price/cash flow) because generally those stocks are less susceptible to adverse market developments than those trading at high multipliers.
In 1949 Graham publishes The Intelligent Investor, which is considered the bible of the value investor. Warren Buffett describes it as: "by far the best book on investing ever written". This book is written for the general public and its greatest merit is to describe the specif intellectual framework an investor needs to survive and thrive in the market.

The 3 main ideas behind value investment are simple and rational:

1. Look at stocks as business: the investor should think of stocks not like small piece of paper whose prices moves up and down randomly but as what they truly are: small pieces of a real life business, which produces products and services and employs people. The value of a stock depends on the value of the business behind it (what Graham calls intrinsic value), and while in the short term the price performance of a stock may outperform/under perform the performance of the business, in the long term the performance of a stock will reflect the performance of the business.
2. Take advantage of the market's fluctuations instead of being fooled continuously by them: now that the enterprising investor know that what he must look at is intrinsic value and that business may sell in the stock market at prices that can be much higher or much lower than their intrinsic value because the market sometimes gets carried away and ends up being too optimistic or pessimistic, his objective is to study stock and determine their intrinsic value. When he as an idea on the true value of a stock, instead of letting himself get carried away by the mood of the market, he can take advantage of that by buying it cheap in a depressed market and by selling it dear in a euphoric market. Graham explain this concept with the effective metaphor of Mr Market, which we will talk about at another time.
3. When you invest, be sure to have an adequate margin of safety: after understanding how he should operate, the hard part of the work of the enterprising investor is the determination of the intrinsic value of a stock. In fact, it's so hard than even for investors with great financial knowledge and experience it is impossible to make a 100% accurate estimate of the intrinsic value of a business. That's because the value of a business may depend also on future developments which are impossible to predict (an extreme example is 09/11/2001: it was an impossible event to predict and it caused terrible losses to many insurance and airlines companies) . It's also more frequent for this developments to be on the negative side than on the positive side. The investor can do two things to maximize his odds of succeeding: he must do everything he can to minimize the error of his valuation and he must make use of a margin of safety to minimize the negative consequence of the risk of being wrong. There is a margin of safety when the price of a stock is inferior to the estimated intrinsic value: the greater the difference, the greater the protection against the risk of having overestimated the intrinsic value of the security.
   

By reading this introduction you have probably understood that the value investor invest in the long-term and doesn't even try to predict the next move of the market, simply because the market fluctuation in the near term are impossible to predict. It's just a waste of time and energy. What you can do is to evaluate what you are getting for the price you are paying.

Now let's get to our days. It looks like that the market has finally returned, after all those years of too generous valuations, to an interesting level for value investors which patiently waited in the certainty that sooner or later all bull markets must end badly and stocks have to return to rational valuations. Since the start of the current financial crisis in July 2007, probably the worst financial crisis for the US since the Great Depression of 1929, the S&P 500 index has lost more than 40% from it's peak in October 2007, European and Asian index have suffered even worse losses. Stock are in my opinion at a level of attractiveness not seen since the early '80 at an early phase of the greatest bull market in history that culminated in the dot-com bubble.