#1 - What is Value Investing
An examination of the differences between trading, speculation & long term focused value investing
In the world we live in, investing does not seem to have a coherent definition. Many people say they are investing, or they define themselves as investors, but their approaches vary drastically. Is a day trader, who enters positions in the morning and exits them in the afternoon an investor? Is an investment banker who trades securities an investor? Is your neighbor who heard that Google is a great investment and buys some shares an investor? Our first goal is to clearly define what we mean by value investing as it pertains to this course.
A Quick Course Note
Don’t worry too much about the wordiness and the concepts you may or may not fully understand yet. All that will happen in time. The main goal here is to expose you to these terms so we can repeat them. Everything will become clear as we move along.
What is Value Investing
According to Investopedia (link), value investing is:
“An investment strategy that involves selecting stocks perceived to be undervalued based on intrinsic or book value”
That narrows our investing definition into the right direction and while this is a good start, we need to fine tune it further. First of all we need to replace the word stocks with companies. The value investing framework that this course aims to teach you focuses on owning businesses, on being a part owner in a company. That is a crucial distinction which we will dedicate at least one full lesson to. That then gives us this definition:
“An investment strategy that involves selecting businesses / companies perceived to be undervalued based on intrinsic or book value”
The next adjustment we need to make is to remove the term book value. We are removing it, not because it has no meaning or importance, but for the purposes of building our framework it is adding too much complexity to the subject at this point. Book value in this framework plays a role in defining intrinsic value.
Now before we come to an initial definition we need to define what intrinsic value means. The best definition comes from the Oracle of Omaha himself, Mr. Warren Buffett:
“The intrinsic value of a business is the present value of all expected future cash flows that a business will generate over its lifetime, discounted at an appropriate interest rate”. (link)
In simple terms, this means that a company will generate money over its lifetime and based on how much money it generates that we as an owner could in theory keep, we can calculate the intrinsic value. This money that the company generates that these lessons will focus on is called Free Cash Flow. We will devote a lot of time on this term as the course progresses, but for now, just think of it as money you as the owner of a business can take out of your bank account after all your business needs are taken care of. If you own a pool cleaning company it would be the money you can take home after you paid the employees, bought all the cleaning supplies, cleaned all the pools etc.
So, the final definition we will use to get this course started is the following:
“An investment strategy that involves selecting businesses / companies perceived to be undervalued based on their intrinsic value, as measured by their ability to generate free cash flow”.
Concepts to remember
In summary the main concepts to keep in mind from this topic is that our investing framework focuses on companies (not stocks, an important difference) and their ability to generate free cash flow (as opposed to net income or revenues).
What Value Investing is Not
To clarify the difference between the value investing framework we’re building and other investment approaches that are out there, let us go through a few examples of what value investing is not.
Speculation
Value investing stands in contrast to speculation. The framework this course teaches is one of careful, deliberate and thoughtful analysis of how a business operates to arrive at a reasonable probability of forecasting the free cash flow generating potential. (see how repetition will be used throughout this course?). Speculation is when you skip this process, because you feel a strong urge to invest, based on short term information, which triggers an emotional reaction in you. For example your neighbor who invests in Google simply because he heard something on the news.
However, while this difference seems clear in theory, it is much more difficult to separate in real life. Our emotions influence us in varying and dynamic ways that can blur the lines between investing and speculating. You may feel a strong sense of missing out on big opportunities, because you are watching CNBC. You may feel fearful of a market decline and have a strong urge to sell your business to avoid further losses. Both of these emotions are very powerful, but must be analyzed carefully before making a decision. Setting the framework on how to deal with that, is the essence of what this course is all about.
Trading
Traders are not value investors, because they enter a stock position, or bond position, or short position not because of the fundamental business analysis, but because of an expectation of stock price movements. That is a completely different game. We will discuss this type of behavior in detail in its own lesson, but for now let us state that trading involves the correct forecasting of future price movements and the percentage of people who do this successfully over a long period of time is infinitely small. This is not what this course is about.
In Closing
This concludes #1 - What is value investing? If you have any questions about this lesson feel free to reach out to me in the subscriber chat. I usually respond in the mornings.
Next week we will begin a longer discussion about the competitive advantages we as individual investors have over WallStreet investors. Is our approach even feasible? What do we need to do (or become!) to give us a chance of success?
Homework
1) Watch Warren Buffet’s 5 minute video on Intrinsic Value
2) For next time read this article written by Warren Buffett. It explains why the value investing framework is a time proven approach for the individual investor seeking to gain an advantage.
I am humbled to be able to share this knowledge with fellow students of investing. I thank each and every one of you for being a subscriber and I hope this content enriches your life.
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