While the value investing community remains a small part of the overall investment landscape, it has grown. A key reason is the long-term success of investors like Warren Buffett, Prem Watsa, and Tom Gayner. Buffett is not only the most highly regarded value investor, but also the most successful investor overall. Many investment managers have taken to copying Buffett’s approach, but is it really possible to become a value investor by reading a few books and desiring to make money? In a letter to investors several years ago, Seth Klarman of The Baupost Group warned of value pretenders, investors who brand themselves as value investors but actually miss the essence of value investing.
How do you determine if you are a value investor or a pretender? The easiest way might be to follow Charlie Munger’s advice: Invert. By considering what would make you a value pretender, you may find out if you are a value investor.
Top 10 Reasons You May NOT Be a Value Investor
Reason #10: You invest based on chart patterns, especially when they point up and to the right. If things like 50-day moving averages, chart breakouts or relative strength are part of your lexicon, you may not be a value investor. Value investing is not about where a stock price has been and what lines it might be likely to cross, but rather about the relationship between price and value.
Reason #9: You assume multiple expansion in your investment theses. If you base your purchase decisions on the likelihood that the market will assign a higher P/E or other multiple to a stock in the future, you may not be a value investor. You may instead be engaging in John Maynard Keynes’s “beauty contest”, an exercise centered on guessing the behavior of others. Value investors independently appraise the value of businesses in order to make an informed investment decision.
Reason #8: You try to figure out how a company will do vis-à-vis quarterly EPS estimates. If you shrink from buying an undervalued company solely because it might miss consensus estimates for the next quarter, you may not be a value investor. Value investors do not play the expectations game, at least not when it involves the market as a whole. It is fine to set your own estimates and base your decisions on whether businesses meet your expectations for value creation. The key is to focus on the margin of safety, i.e., the difference between price and value.
Reason #7: You base your decisions on analyst recommendations or subscribe to newsletters promising big returns. If you seek out information on the stock ratings of Wall Street analysts prior to making an investment decision, you may not be a value investor. Analyst ratings are highly skewed toward buy recommendations and are tainted by a desire to win investment banking business. Moreover, most analysts are anything but true value investors, issuing buy ratings after stocks have already run up and downgrading stocks after their prices have collapsed.
Reason #6: You use P/E to Growth (PEG) as a key valuation metric. If you are willing to pay a high multiple of earnings for a fast-growing company, you might be a growth investor or a momentum investor, but you are almost certainly not a value investor. True value investors try to get growth for free. They pay for the free cash flow a company throws off today, with future growth a bonus rather than a requirement.
Reason #5: You use EBITDA as a measure of cash flow. If you have convinced yourself that EBITDA is an appropriate measure of cash flow, you may not be a value investor. EBITDA has the advantage of normalizing for leverage and taxes, but it also “normalizes” for depreciation and amortization. The latter is an expense that not only varies widely among businesses, but also has a big impact on intrinsic value. If D&A is high, a company likely has to spend a large portion of operating cash flow on capex. This decreases the amount of cash available to be returned to the owners of the business.
Reason #4: You would worry about your portfolio if the market closed for a year. If you need a market price in order to feel like your stock investments are worth something, you may not be a value investor. Equity markets do not bestow value upon stocks. Markets provide an opportunity to buy or sell at prices that may or may not have much to do with intrinsic value. Just like you do not seek a quote on your home every day, you should not view the liquidity of stock markets as a key feature of equity investing. Value investors look to the business rather than the market for their investment return.
Reason #3: You make investment decisions based on the activity or tips of others. If you buy an equity simply because an investor you respect or, worse, a friend has made the same investment, you may make money, but you are not a fundamental value investor. Value investors make decisions on the basis of price versus value. How can you estimate the value of a business if you have not done the fundamental work to understand it?
Reason #2: Your investment process centers on the market opportunity. If you view the growth of a market or a country as the primary reason for buying a stock, you may not be a value investor. Warren Buffett has said that the key to investment success is not how quickly an industry or a company may grow. Rather, the key is the magnitude and sustainability of a company’s competitive advantage. The latter allows for pricing power, a key determinant of profitability and returns on capital.
Reason #1: Your investment theses do not reference the stock price. If you use arguments like “this company is gaining market share” or “this is a low-quality business” without referencing the market price, you may not be a value investor. Value investors do not make investment decisions without accounting for the market quotation of a business. While a value investor may prefer to buy an above-average business at a below-average price, he would also consider buying an average business at a “way-below” average price. There is a price for everything.
Still a Value Investor?
If you are feeling a bit shaken in your beliefs or consider the above list too restrictive, don’t worry. All of us have thought or acted like value pretenders at times. The temptation to succumb to the approach of least resistance is too great to ignore completely. What matters is that we are aware of the things to avoid, and that we view investing as a never-ending learning process. Buffett continues to learn well into his 80s, so why should we feel that we’ve already achieved perfection?