Me: You should never forget the concept of value investing even during such times, sir!
Investor: Oh, you mean I should look out for more stocks trading at cheap valuations.
When I talk to a lot of investors, I come across a few myths, which are in persistence for quite a long time. And one such is the concept of value investing (as highlighted above).
The term 'value investing' is mistakenly taken as buying stocks with low P/E ratio or P/B ratio.
This myth that goes concurrently with 'value investing' as propounded by Warren Buffett is challenging to break unless you look at value investing from the similar lens of Warren Buffett. But let me come to that later.
Before that, let me give you a brief background about where this concept came from.
Debunking the myth
This belief of investing was coined by Benjamin Graham, also called a cigar-butt style of investing. So, what is this approach all about and how it is different from value investing as postulated by Warren Buffett.
Let's take one thing at a time.
Cigar-butt approach is all about picking up discarded businesses that are trading at a considerable discount to book value and selling them at a profit later.
The theory is similar to cigar-butt found laying on the side of the road, with one good puff left in it. How would you know if the discarded cigar butt has one more puff left in it?
While identifying such businesses, Benjamin Graham mainly looked for net value which is calculated as:
Net Value = Current Assets - (Total Liabilities + Preferred Stock) / Outstanding Shares.
Meaning, if the company had to liquidate and pay off its obligations, net value is what the shareholders would be left with. If the stock price is below net value, it's a good bargain purchase.
So how is this different from Warren Buffett's concept of value investing?
Warren Buffett has shunned this style of investing long back. Yes, he bought a few businesses based on cheap valuations before, but he doesn't practice them or recommend them either now.
In the 1989 Berkshire Hathaway Annual Letter to shareholders, Buffett explained, "If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit."
Click here if you wish to read stock market investing lessons from an investor who inspired both Warren Buffett and Benjamin Graham.
The problem with cigar-butts
These businesses are either loss-making, burdened with high debt or inconsistent cash flows. Hence, they are available for cheaper valuations.
While talking about the "Mistakes of the First Twenty-Five Years" in the 1989 annual letter, Warren further explained, "First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre."
The point here to note is not all businesses trading at cheaper valuations should be considered as lousy businesses. On 23rd March 2020, we saw many fundamentally sound businesses going down by 10-15-and even 30%. As a result, many good businesses were trading at cheaper valuations. So, what should an investor do during such times: Simple, buy more quality businesses!
The idea of value investing
While purchasing any stock, it is essential to look at how wonderful the business is. With this, it is also important to understand if it enjoys any distinct advantage as compared to competitors which allows it to protect its market share and profitability, also called as an economic moat in the parlance of investing.
One should remember Warren Buffett's famous quote in his letter to shareholders of Berkshire Hathway at the peak of the 2008 financial crisis, "Price is what you pay, and value is what you get!"
Rather than judging a stock by its market price or cheap valuations, it is essential to evaluate a share by its fundamental strength.
It is always rewarding to buy a fundamentally solid stock by paying a little more for it rather than owning a stock which only reflects cheap valuations and low returns.
Investors often make this crucial mistake of looking only at the stock price or P/E ratios, because that is the number which appears everywhere be it stock tickers, news channels or business newspapers. To be honest, it has very little significance unless used in conjunction with other parameters.
A value investor should rather focus on the stock's intrinsic value rather than the stock price or cheaper valuations. Remember if there is a value associated with a stock, its share price will go much higher under the right circumstances, whereas a low-priced stock with no value will sink even further.