Warren Buffet is widely know as the most successful investor of all time. Needless to say, we can learn a thing or three about portfolio management from this multi-billion dollar magnate. One of them is value investing.
So what is value investing? You may argue that you all your investments have value – whether it be tangible, legal or market value. This may be true, but what makes value investing different is that is focuses on the intrinsic or “real” value of an investment, as opposed to its market value.
The concept of value investing was developed by Ben Graham and his associates at Columbia Business School in the Unites States after the Great Wall Street Crash of 1929. In those days, the stock market could be compared to a casino, leading to its ultimate demise. To remedy this luck-based approach, Graham hoped to develop a system whereby one could calculate the intrinsic value of a stock and compare it to its market price today – this would inform the decision of whether to purchase or sell that stock.
So how can you implement value investing in your own portfolio management?
The concept is quite simple. When you assess a potential investment, you look at it from the perspective of the cash flows that you would receive from it in the future. For example, if you buy one share in Apple today, you will receive dividends in the future. You will therefore have a cash outflow when you purchase the stock, and a cash inflow when you receive dividends in the future.
The same principle can be used to analyse a property investment. Your initial outflow of money is what you pay for the purchase of your house or an initial deposit, and your cash inflow would be the rental you receive from your tenants over time. Comparing your cash inflows and outflows from a business is essentially how you can determine your assets’ intrinsic, or “real” values.
Value investing in action
Here’s an example of how you could apply your intrinsic value calculation to make an investment decision:
- After doing your series of cash flow calculations, you work out that the intrinsic of actual price of apple today is $200.
- You go to your stockbroker and he tells you that Apple is trading on the market today for $115.
- You know that the current market value is less than its actual value. This means you should buy it because the market has underpriced Apple at only $115, when it’s actually worth $200.
- You see a bargain and buy the stock now, hope that the market realizes the mistake, and that the price will eventually increase to $200, earning you a tidy profit of $85.
But there is a calculated catch
Now you may be thinking to yourself: “Great, getting the edge over the market is very easy, all I need to do is be able to calculate an asset’s true value; it can’t be too hard?”
Unfortunately, as easy as these equations may seem, projecting the future cash flows from your investments can actually be quite a difficult thing to do. Portfolio management analysts spend months refining the values they use in the models to make the best possible investing decisions for their clients and investors.
So you may not be a mathematician or analyst, but the overwhelming lesson we can learn from value investors such as Ben Graham and Warren Buffet is to have a system to analyze and make decisions about investing, no matter how technical or simple your system may be.
The other day, a friend of mine said to me that he thinks he could double his money in a year if he bought an apartment in the Summerset Vista. I said: “OK, but what would you base your decision on? How are you finding the value and predicting your future returns?”
The point is, have a system and stick to it. The nature of value is itself subjective, so develop your purpose and method and try not to guess and gamble.
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