The profit lies in buying cheaply – or: don't pay too much!

 

This wise and classic business saying is still valid today and is vital if an investment is to succeed. If you can aquire an asset or investment at a price that is well below its actual or true value, this margin will most probably be the profit you can expect.

On the stock market such an approach of buying stocks and shares under their true value is called value investing. It was founded in 1934 by Benjamin Graham. Under the impact of the negative experiences of the great depression Benjamin Graham followed the aim of being able to distinguish between a real value investment and pure speculation.

Investment rather than speculation

 

Intrinsic value and emotional action

 

Buying opportunities during anxiety and panic

 

Longer holding period and low transaction costs

 

Unique long-term success of value investing

 

Anti-cyclic character of the value approach

 

Value expertise of experts

Investment rather than speculation

Graham realized that all listed companies have two „values“:

1. the market price, i.e. the valuation of the company on the stock market, which is a reflection of the current market price.

2.the actual value of a company, which is also referred to as the inner or true value (intrinsic business value). This is based on the proven business model of a company and results in the profits of a complete business cycle. Therefore the true value of a company is the price a competitor would be prepared to pay in the case of an aquisition or merger. This value would thus be recouped by the business over a reasonable period of time.

Alternatively, the intrinsic value can be determined by breaking down the individual assets of the company. In this case the the owner estimates the revenues that can be achieved when breaking down the company.

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Intrinsic value and emotional action

In fact, the share price of a company's long-term focus lies on the intrinsic value, while in the short or medium run it can vary greatly from this price in both directions. This is particularly the case when market participants are no longer guided by fundamental criteria of enterprises, but just follow the herd mentality of the masses and buy companies just because everyone else has already done this and continues to do so. So-called glamor stocks are bought because they are chic and fashionable.

The effects caused by this herd mentality irrational exuberance can lead to unbridled euphoria and massive exaggerations and over-valuations of companies on the stock markets, such as those during the technology bubble in the late 90s could be seen for Internet stocks as well as on the Neuer Markt.

On the other hand, fear, panic and doom and gloom mentality with seeming hopelessness can lead to exaggerated selling pressure when the slogan "Save yourself who can" rules, it is then when all stocks and shares regardless of their price and/or value are thrown onto the market.

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Buying opportunities during anxiety and panic

Value investors only buy if the market price is significantly below its intrinsic value, ideally between 40 and 50% This spread between the market price and net asset value is referred to as a safety margin or "margin of safety". A sufficiently high margin of safety protects against permanent loss of capital, that is why the security of the capital employed and the prevention of any loss of capital are top priorities for value investors.

In the short term, however, interim loss phases are possible, these can`t be avoided, even when applying the value approach. This is especially true in those phases in which valuations in the stock market are totally unimportant. However, in the long term the safety margin of value-oriented investment leads to a considerably low investment risk, especially against the broad equity market.

Value investors must therefore be patient. So it takes some time - often up to 5 years - until the mispricing made by the market - which gave the value investor the opportunity to buy in the first place – has been recognized. Share prices then bounce up to their true value. That is why value investors have a time frame of 3-5 years.

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Longer holding period and low transaction costs

This patient and far-sighted investment behavior is reflected in a very low turnover rate of the titles in value funds. With an average holding period of the shares of 5 years, there is only an annual turnover rate of around 20%. Ordinary index orientated funds have a turnover of 100%, also 200% are possible.

This low turnover within value funds leads to very low transaction costs of about 1% p.a. compared to other actively managed funds. This obviously has a positive effect on the overall performance.

 Value-investors sell their shares when the market price is approaching the intrisic value, or if this has been achieved. The sales proceeds are then reinvested in other undervalued stocks with the highest safety-margin.

When using the value investing strategy in a disciplined manner investors will achieve above average returns in the long run. This is based on the anticyclical investment approach where one never pays too high a price for a company.

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Unique long-term success of value investing

The success of this unique investment approach over many decades could not be copied when using other strategies. This was proven in various studies for example by the noble price winners Eugene Fama and Kenneth French. In contrast to the results of the efficiency theory the price of a stock quoted on the stock exchange does not reflect the inner or true value of a company. In practise it differs significantly upwards as well as downwards.

This fact can be well explained by the human emotional and irrational investment behaviour which is driven by excessive euphoria and leads to extreme over-valuations – or in the case of excessive pessimism to extreme under-valuations of companies listed on the stock exchange.

The value-investor uses this mispricing to his advantage by avoiding companies that are too expensive and by buying undervalued stocks.

In this way he achieves significantly higher yields than the overall market and has an investment with a much lower risk. However only a few convinced investors are successful when implementing this investment method such as the investment legend Warren Buffett in Omaha / Nebraska, who made it to one of the richest men in the world with his investment company Berkshire Hathaway.

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Anti-cyclic character of the value approach

While the value approach sounds coherent and theoretically well understood, it can not be simply put into practice by the majority of investors. The value investing approach means continuously to go against the market and the majority. This is why undervalued stocks and buying opportunities can be found especially in areas that are misunderstood neglected and avoided by the market and the masses.

Since it lies in our human nature to follow the crowd, investing via the value approach is absolutly contrary to our human nature.

Therefore, the value approach is unsuitable for the masses of investors who prefer to follow the trends and feel secure in the herd. Investment and planning reliability and very attractive returns will only become reality for a minority of independently minded investors who are able to make decisions that deviate significantly from the general opinion.

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Value expertise of experts

Because private investors rarely implement the value approach successfully due to human nature and the lack of fundamental knowledge when trying to assess the true long-term value of companies, it is recommended to use the help of value experts with years of expertise and strong convictions.

These should have unrestricted access to the global investment universe because restrictions regarding regions, sectors or themes would limit the opportunities right from the beginning.

With the help of proven value-experts this global investment spectrum can be covered very well. In addition to this, the risk of making wrong decisions by the private investor due to one-sided and useless market coverage and media is greatly reduced.

Although there is not the one and only "value" approach and a number of "sub-styles" exist with different orientations – all value strategies followed by value-experts have the same goal and that is:

„Do not pay too much for your investment in order to secure future profits by having bought cheaply“.

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Investmentphilosophy:

"If a company is worth a dollar and I can buy it for 40 cents it will be good for me in the long run."

Walter Schloss