Getting Started In Value Investing

Chapter 1: The 5 Misconceptions of Value Investing

• “We’ve long felt that the only value of stock forecasters is to make fortune tellers look good.
Even now, Charlie and I continue to believe that short-term market forecasts are poison and
should be kept locked up in a safe place, away from children and also from grown-ups who
behave in the market like children.” – Warren Buffett
• Value investors typically use a bottom-up approach, which means identifying investment
opportunities one at a time through analysis of financial statements
• The vast majority of investors employ a top-down approach consisting of the following three
steps:
1. Making a prediction about the future
2. Discerning its effect on the investment
3. Making the trade
• The author believes this is a very risky method because it is subject to error at every step in
the investment process
• The investor has to make a macro bet on the economy that is correct
• If the macro bet does prove to be correct the investor has to predict correctly how the macro
thesis will affect the sector, industry and company
• If the investor is able to correctly make a macro bet and accurately predict the impact on the
sector, industry and company he then has to make his trade before the rest of Wall Street
allocates money to this trade
• The author states that bottom-up investing consists of company specific analysis which can
be found in annual reports and the SEC filed 10-k
• The investor uses the information from his analysis to determine the intrinsic value of the
company
• If the intrinsic value of the company is trading below the quoted stock price you buy the
security and wait for the value to rise
• The author believes that if you buy the security cheap enough you are taking risk out of the
investment process
• An example would be an investor, who after reading Coca Cola’s annual reports, determines
the company is worth $50 per share
• The company is trading at $35 which is a 30% discount to the intrinsic value estimate
• Even if the true value is $45 not $50 a healthy return can still be realized on the investment
• One of the most difficult challenges for bottom-up investors is the lack of activity required
• The investor must be patient and give the investment sufficient time to realize the intrinsic
value estimate
• The author clearly believes that bottom-up investing is a much easier pursuit than top-down
investing because it leaves less chance for error during the investment process
• “Nobody can predict interest rates, the future direction of the economy, or the stock market.
Dismiss all such forecasts and concentrate on what’s actually happening to the companies in
which you’ve invested.” – Peter Lynch
• A top-down investor has to make an accurate prediction and the determine the magnitude of
that prediction
• For example if the investor concludes the U.S. dollar will decline he also has to predict by
how much
• After he has established how much of a decline will take place he has to figure out whether
this has already been priced into the specific security he is picking
• The bottom-up investor can take company specific events and incorporate them into his
intrinsic value estimate much more precisely
• For example if a sales channel closes up he can assess the potential lost revenue from that
channel and integrate it into his intrinsic valuation of the company
• Independent thinking is the trademark of value investors they absorb facts and come to their
own conclusion
• “If you formed a conclusion from the facts and if you know your judgment is sound, act on it—
even though others may hesitate or differ. You’re neither right nor wrong because the crowd
disagrees with you. You are right because your data and reasoning are right.” – Benjamin
Graham
• The 5 Misconceptions of Value Investing
1. Much of the information needed to research a stock is too costly, hard to get and
difficult to understand
§ Author believes this to be false and states that all relevant information can
be found in SEC registered reports
§ Successful investors should read five years worth of these reports in order
to gauge managements track record of delivering results to their equity
owners
2. You can’t beat the stock market
§ This is true if you only listen to stock tips and don’t perform your own
fundamental research
3. Value investing is all about buying stocks trading at low prices
§ Value investors are never concerned with only the quoted price of a stock
§ They are concerned with the quoted stock price in relation to the
underlying value of the business
4. You have to be an accountant to understand a company’s financial statements
§ Accounting is the language of business and knowing the basics is very
beneficial, but complex math is not required
5. You can make more money investing in growth stocks than value stocks
§ There is no difference between a value and a growth stock
§ Value investors buy companies with earnings growth, but they are more
conservative and cautious regarding how much they pay for that growth
§ Growth investors anticipate that high rates of growth will continue far into
the future
§ “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as
twaddle. It’s convenient for a bunch of pension fund consultants to get fees
prattling about and a way for one adviser to distinguish himself from another.
But to me, all intelligent investing is value investing.” – Charlie Munger
§ Investors should look at the profit margins, operating incomes, and return
on equity of a business, regardless of whether it is labeled a “value” or a
“growth” stock, and then factor in future earnings growth to determine
whether the stock is undervalued or overvalued
§ “The two approaches are joined at the hip: growth is always a component in
the calculation of value. As long as you are buying great companies for less
than their real worth, don’t give a darn as to what investing style it is called,
just watch your account balance rise over time.” – Warren Buffett
• Financial statements provide insight into the company’s financial health
• There are four critical statements
1. Balance Sheet – shows the assets, liabilities and net worth of the company on a
specific date
2. Income Statement – shows the money that came in through revenue and went out in
expenses during a quarter or year
3. Cash Flow Statement – shows where money came from and where it was spent
during a quarter or year
4. Statement of Change in Stockholders Equity – shows the change in equity during a
quarter or year
• Key Points
1. Bottom-up investing makes more sense than top-down investing. It places unknown
factors within your control.
2. Independent thinking is a trademark of value investing, as exemplified by Warren
Buffett, today’s best-known and greatest value investor.
3. The goal of investing should be to buy businesses that are selling below their
underlying value.