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Fundamentals of Value Investing

By Sensiblelessons @sensiblelessons
Fundamentals of Value Investing

Much like how you can find clothes, products, and other items on sale, or at a "discount" at the store sometimes. Buying businesses is not so different (aka buying equities/stocks). However, rather than a particular entity (e.g. a retailer) who is setting the prices, stock prices are generally determined by the "open market" (meaning the buyers and sellers), which can be influenced by economic factors, investor sentiment, impactful events, etc. In this school of thought, the point that underpins value investing is, markets are not always perfectly efficient or priced correctly. It's accepted that generally, more often than not and over a long time horizon they tend to converge to "correct prices". However, when rare opportunities present themselves and mispricing occurs if you are able to identify that, you can buy businesses on sale or at a great "value" / bargain and get a great investment.

There are 3 core underlying principles:

1. Fundamentals of a stock / Business

    • A stock represents a business and should be treated as such. When you are buying a "stock" you are buying a piece of a company, and not just a ticker symbol. In a way, you are buying your entitlement to part of the future earnings of a company and business. It's much more powerful than just a ticker/symbol or numbers floating on the tape; Before buying a stock you should consider; the company at this price/valuation would I pay for it relative to what it's earning? It's quite easy and accessible to buy stocks nowadays, but there is a real learning curve, and individual retail investors may often forget this fact.
    • Takeaway: stocks aren't just letters and $ on a sign; they represent a real valuation of a business. And therefore, their valuations/prices of the business have to be grounded to the performance and wellbeing of an actual business;
        There have been bubbles; where people buy securities on the basis that they've seen the price go up and up and they don't want to miss out. They are betting on the idea that the next person will buy for more than you paid for. This is speculating/gambling and you are likely to get burned; the price/valuation of a stock has to be tied to a real business's performance/profitability/well-being/or future prospects; else you are speculating.

2. Concept of Mr. Market

    • The "Stock Market" is just that; a marketplace driven by supply and demand. There is a great analogy (,1949%20book%2C%20The%20Intelligent%20Investor. )
    • The central concept being; "the market" will give you the option to buy or sell a stock at a given price each day. Sometimes it'll quote stocks at an overpriced rate when markets are optimistic, and sometimes it will sell you things at a discount when markets are pessimistic. For the most part, it will sell to you at a fair price. However, you as the individual investor are free to choose when to interact with the Market.
    • The takeaway: the market (like all things) aren't perfect, and therefore gives rise to certain opportunities of mispricing sometimes (i.e. a stock can be worth less than what it's really worth/intrinsic value... and vice versa). However the game is advantageous as a whole if you play correctly; as you have the option of never buying if you don't want to, and only buying when you feel confident that something is undervalued.
        The difficult question becomes: how do you determine intrinsic value?
    Buffet says this form of construct is extremely advantageous because 1) even if the market is offering overpriced stocks, you have the option of never buying and you are at no obligation too. 2) however when you identify a great bargain, then you "swing for the fences" (aka make a hefty investment)

3. Margin of Safety

      This is the key concept of value investing that minimizes potential losses. Margin of safety refers to the "buffer" between a stock's market price and its intrinsic or real value. In the past Buffet has referenced a 50% margin of safety, meaning you'd only purchase a stock if you find that the market is selling at 50% or less of the actual worth/intrinsic value of the company to (be based on reasonable assumptions about its company's cash flows and growth). In this way, even if you were wrong about your valuation/assumptions there is a safety net buffered in so that you don't lose money (or at least minimize your odds of losses). Other analogies that have been used to illustrate this concept is "free" lottery tickets or finding mispriced bets.
        Where naturally any attempt to forecast the future is subject to unpredictability, and never 100% guaranteed. By buying a company at "half" its intrinsic value (if you can find the opportunity to), you give yourself a cushion in your assumptions and as well to unfavorable conditions that may play out in the future.

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