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What is Value Investing?

Since Warren Buffett took over Berkshire Hathaway in 1965, its book value (which has increased at a roughly equal rate to the growth of its investments) has grown by 22.2% per year, compared to an 10.4% annual gain in the S&P 500 (assuming dividends were reinvested).

How did he do it?

Essentially, Buffett views stocks as similar to bonds; when you invest in a bond, you expect to be repaid in interest. Similarly, when a value investor invests in stocks, he expects to eventually be repaid in dividends. Here's how it works:

A company earns a certain amount in income. It pays part of this income to its shareholders, while the rest is reinvested in the business. This reinvestment, if done at a high rate of return, will increase the value of all future dividends. We can use these figures -- the company's income, the portion of this income reinvested in the business, and the rate of return on these investments -- to try to calculate the value of a company's future dividend payouts. This number is known as the business's Intrinsic Value, and value investors seek to buy stocks that are trading at a significant discount to this value.

Notice that if you were to buy a stock and hold it forever, without ever selling, you would only profit from dividends. And since an undervalued company is trading at a discount to the value of its dividends, someone who holds an undervalued stock forever will be expected to outperform the market. In fact, the longer you hold a company, the more dividends matter. So, if you hold an undervalued company for a long period of time, it will probably outperform the market. (Of course, if you're wrong about the company and it isn't undervalued, it probably won't outperform the market no matter how long you hold it.)

This type of investing has an additional advantage. If an investment is trading at a discount to its fair value, it has a margin of safety. That is, the investment will likely do well even if it performs below expectations. So an undervalued stock is safer than an equivalent, fairly valued stock.

This type of investing is only possible if future dividend payouts can be predicted. This, in turn, can be done only if future earnings are predictable. So, we must focus our attention to predictable investments.

Buffett's favorite type of predictable investment is one that:

1) earns high returns on capital invested in the business,

2) has a strong competitive position that will ensure stable marketshare, and

3) is well managed.

For instance, take Coca-Cola. The company earns returns on capital in the 20-30% range, has an unassailable competitive advantage (created by brand loyalty, its distribution system, its size, as well as some other facors).

Of course, there are other types of predictable investments, such as real estate. These can also be valued, and may be discussed on this website.

A word of warning: Buffett's results are unusual, and you shouldn't expect those kind of results. It's very difficult to outperform the market at all. But regardless of whether or not you are able to find undervalued companies, value investing ideas will help you avoid speculative bubbles. A disciplined value investor would have avoided the high priced tech stocks of the late 90's, and would not have lost too much in the subsequent crash. By avoiding irrationally overpriced stocks, you should be able to avoid some of the market's risk.