Sunday, March 22, 2009

Value Investing - Buying Shares For The Long Term

Investors buy shares in Australian companies for many reasons. Some buy stock in a company simply because they think the share price will go up, some may purchase based on the advice of their stock broker and some may even take the plunge based on a tip they received down at the pub on the weekend. However, today I'd like to discuss an alternative approach to the Australian stock market called value investing.

Value investing is an investment strategy or paradigm based on the teachings of Benjamin Graham and David Dodd going right back to the major sharemarket crash and subsequent great depression in 1929. In a nutshell, it involves buying shares at prices which are a significant discount to their intrinsic or underlying value based on fundamental analysis.

For those that are serious about buying shares and who have not heard of Benjamin Graham, I suggest you take the time to find out about the man. Security Analysis, originally published in 1934, became the foundation upon which an entire profession was built. While Security Analysis is worth reading, another of Graham's books titled The Intelligent Investor is much more accessible and I would say compulsory reading.

Perhaps the most famous of Graham's students is Warren Buffett - a renowned value investor and one who has consistently outperformed the S&P 500 index throughout his career. Other perhaps lesser known students, although each successful in their own right, include Irving Kahn, Bill Ruane and Charles Brandes. To find out more about the success of his students, read Buffett's article - The Superinvestors of Graham-and-Doddsville.

One of the most important concepts to come out of Benjamin Graham's writings is the margin of safety concept. The idea is that you're buying at a discount to intrinsic value, thereby giving yourself a buffer or margin of safety in case anything goes wrong.

One of Graham's classic methods of valuation was to use net current asset value. This approach calculated the value as being the company's current assets (I think from memory it may even have even been just cash and cash equivalents) less all liabilities. If you could buy shares in a company at less than two thirds of its net current asset value, Graham believed you had a low risk situation with significant upside potential.

So how do we apply these teachings? We need to understand the distinction between price and value. Price is what people are willing to pay for any given share while value is what it's actually worth. Trading and technical analysis involve looking at price and volume indicators, but does that really tell us what the company is worth and whether the current price over or under-values the company? Using fundamental analysis, we delve into the financial statements of the business to find out what it's really worth - it's value. I found a really good discussion of this topic in this article - Do prices Really Matter?.

Buying shares in the current market conditions requires patience and discretion. I suspect the days of making money by just taking advantage of the rising Australian sharemarket may be over for a while. I think the principles taught by value investing will provide you with useful tools during this period.