“To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework…. ” — Warren Buffett

“Value investing” is an investment framework that most people would benefit from in their equity investing approach, yet most people (even those who work in adjacent professions such as finance or consulting) are largely unaware of this framework.

When applied correctly, value investing practitioners has been consistently successful in generating superior returns versus market averages, and their superior returns has added up to large benefits in the long run.

With this post, I’ll seek to give a brief introduction to what it is, hoping to encourage readers to learn more about it.

I could easily have been unaware of this framework myself, but I was fortunate enough to be at the right place at the right time in 2008 to have a very early introduction to this discipline.

It all began on the morning of September 15th 2008 when I walked into JPMorgan Chase investment bank’s Victoria Embankment offices for the first time. I had moved to London few days ago, and everything felt new and exciting. We had a 2-week training ahead before we moved into our roles, but that first day proved to be the highlight of what would turn out to be a dramatic “crash course” in finance.

It turns out, that very same morning one of the largest investment banks in the world, Lehman Brothers, had been declared bankrupt. There were thousands of Lehman employees few kilometers away from us who were being told their employer was no longer in business.

Of course, I did not fully understand the gravity of the situation even after virtually all key speakers cancelled their training sessions.

Over the following days and weeks, it was impossible to be not fascinated with what was going on. Institutions viewed as the “bluest of the blue chips” just a year earlier were going bankrupt one after another, single-day drops in market that were modelled to be very unlikely were happening back-to-back for days, and the “D” word (“depression”) appeared in the press increasingly often.

An education in electronics engineering did not help much in understanding why banks fail, why one bank’s failure could bankrupt another, and why suddenly virtually every business around the world (even those that have seemingly unrelated business models) were worth less than half of what they were worth a few months ago.

Engineering disciplines are endeavours of precision. One thing that immediately became clear was that finance, and financial markets in general, did not rely on nearly as much precision. Their seemingly imprecise and illogical nature led to a strong intellectual curiosity and fascination.

It definitely was this curiosity and fascination that led me to read everything I could find on subject. It was probably my engineering background that gravitated me towards Benjamin Graham’s “Intelligent Investor”. Once I read it, I decided I had found the framework I needed to take advantage of this seemingly imprecise nature of the markets.

In a nutshell, Ben Graham’s “Intelligent Investor” laid out a very mechanical and precise “Investing” framework. It did so by detailing the two core concepts an investor must understand for making sound investment decisions: “The margin of safety” and “The right way to think about about market prices”. We should probably spend some time on these concepts:

“Margin of safety” refers to buying pieces of businesses (stocks) at such discounted prices that, given the company’s expected performance trajectory 2–3 years into the future, the investor would have a low likelihood of suffering any “losses on principal” (i.e. negative returns). That same discount must also make it very likely to obtain strong -or as Ben Graham would put it, “very satisfactory”- returns on investment.

An exercise in trying to calculate margin of safety would clearly require making a set of assumptions regarding the company’s future, therefore value investors would choose to stay away from companies whose future is hard to predict by nature. They would instead focus on companies for which a reasonable assumptions on business performance are possible to make. Such companies are the ones with simple, predictable, high quality businesses with “wide moats around them”, meaning their financial performance has a low risk of worsening due to a new competitor or a changing market landscape.

Once a reasonable set of assumptions are made, the investor could then look for a price with a wide enough “margin of safety” such that the investor’s assumption set would have to be substantially wrong before her investment can generate negative returns.

The second concept, “the right way to think about about market prices”, requires further discussion since it is arguably even more central to any value investment operation than “Margin of Safety”. After all, if the proponents of the “Efficient Markets Hypothesis” are correct and the market prices always reflect the fair value of a business (i.e. if markets are always “efficient”), then there can be no margin of safety to speak of. Markets would at all times be making the correct set of assumptions regarding future of any company, and would be reflecting a fair price based on those correct assumptions. If a company appeared deeply discounted based on an investor’s assumptions, then investor’s assumptions would have to be wrong.

This is clearly a dramatic way to think about market prices, yet surprisingly it is very much at the core of most academic work on financial markets. (Nobel laureate economist Robert Schiller once called this theory “one of the greatest intellectual mistakes of our time”)

The value investors’ view on market prices is a bit different: They believe markets reflect a reasonable price for equities most of the time. They believe it is a “voting mechanism” through which a very large number of people deploy enormous amounts of capital to establish a fair price for each security. However this “voting mechanism” fails often enough (even for companies with highest market valuations) that an investor looking in the right places can identify outstanding businesses sold dramatically below their true value.

The question is then, how could this “voting mechanism” possibly fail often? After all, there are many bright individuals backed with tremendous amounts of capital constantly seeking profits in financial markets.

Joel Greenblatt, a very successful former fund manager who currently teaches a value-investing course in Columbia University, gives one of the most concise answers to this in his book:

“…So I ask my room full of smart, sophisticated students to explain why. Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much? Well it’s a good question, so I generally let my students spend some time offering up complicated explanations and theories.

In fact, it is such a good question that professors have developed whole fields of economic, mathematical and social study to try to explain it. Even more incredible, most of this academic work has involved coming up with theories as to why something that clearly makes no sense actually makes sense. You have to be really smart to do that.

So why do share prices move around so much every year when it seems clear the values of the underlying businesses do not? Well, here’s how I explain it to my students: Who knows and who cares?

Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe it’s hard to decide what a fair rate of return on your purchase price is. Maybe people get a little depressed sometimes and don’t want to pay a lot for stuff. Maybe people get excited sometimes and are willing to pay a lot. So maybe people simply justify high prices by making high estimates for future earnings when they are happy and justify low prices by making low estimates when they are sad.

But like I said, maybe people just go nuts a lot (still my favorite).”

My personal view on the reason why these fluctuations occur is probably as wrong as anyone else’s, and it is by no means a novel idea. It is also not central to a value investing strategy since all a value investor needs to know is that market prices do fluctuate and they do not always reflect a fair price. Regardless, I share my view with investors since it is relevant for them to understand where we view our “edge” to be derived from:

In our view, the core reason behind the observed market inefficiencies is the dominance of short-term traders in exchange trading volumes. The daily buying and selling activity for most securities are so dominated by market participants focusing on short-term returns (e.g. hedge funds, high frequency traders) that the views of long-term investors are reflected with significantly less weight on prevailing prices.

In other words, long-term investors get to cast a lot less votes than the short-term traders in this “voting mechanism”. This means that the short-term guessing game regarding how the market price of a company will change in a quarter/month/day from now can push prices away from the long-term fair price of underlying company, causing a valuation that is disconnected from the long-term worth of the business.

As an example, if the short-term traders believe that Walmart’s stock price will fall due to bad economic data that will get published in a few weeks, they can try to get ahead of that price move and sell today, hoping to generate a profit from this short-term move. In cases of large trends such as bad (or good) economic newsflow or industry-wide problems, this selling (or buying) can be done with so much capital for such prolonged periods that a large disconnect can develop between the short-term speculators’ equilibrium price and long term investors’ fair price. Since short-term traders have a disproportionately large weight on the market “voting mechanism”, market price would settle at a level closer to their equilibrium price, presenting a buying (or selling) opportunity for the long-term investor.

This hypothesis would be aligned with the observation that markets are significantly better at predicting good or bad news coming up in three to nine months, while consistently failing to reflect the true long term value of businesses few years into the future. As can be seen for even the largest companies in the world, company valuations can (and do) generate returns higher than 20% within 3-month periods despite having absolutely no change in the underlying business fundamentals and no news about the company.

Such cases of price disconnect create an outstanding advantage for investors who understand how to value businesses, how to think about market prices, and how to take a long-term view in investing. This is the anomaly which the “value investors” seek to capture, and profit from.