>10 Value Investing Tenents

In a good book that all investors should read “What is Value Investing?”, the author, Lawrence A. Cunningham, summarizes the ten principles of value investing.

“Value investing is ultimately common sense applied to capital allocation. Its general philosophy and key tools summarized in previous chapters can be distilled further. Worth extracting are the following 10 value-investing tenets.

MR. MARKET PRINCIPLE

Value investors make a habit of relating price to value. They recognize that stock markets rise and fall. The prices of individual stocks likewise swing widely. In the case of stocks and stock markets, a bull exhibits excessive optimism, a bear excessive pessimism. Dreary rationality, where value investors live, lies in between. There are stocks priced above what the underlying business is really worth and stocks priced below that. While over long periods of time the process evens out, the ideal strategy is to search aggressively for investment prospects priced below value.

BUSINESS ANALYST PRINCIPLE

Value investors do not guess when the market or a stock is at its peak, trough, or specific points in between. There will nearly always be times when some positions are priced attractively compared to value and others when the opposite is the case. During periods characterized by bullishness, as the late 1990s, there are fewer value opportunities; during bearish times, as in the early and mid-2000s, there are more. The universe of prospects enlarges as markets fall and contracts as they rise. Tendencies in either direction reinforce themselves, as pes­simism or optimism spreads. This requires knowledge of business, accounting, and valuation principles.

REASONABLE PRICE PRINCIPLE

It is never worth the value investor's time or effort to forecast when tops and bottoms are reached. If price is a fraction of value, value investors buy, knowing that there is a chance that the price will fall lower. Over long periods of time the gap will narrow and often reverse.

PATSY PRINCIPLE

Patsies lose money in stock investment. Market timers and others with the inability to assess the underlying value of businesses should not even participate in the art of stock selection and investment. Those so afflicted are like the patsy in poker, the person unaware that his funds will shortly be held by someone else. Poker and stock-picking are tricky enterprises, not for the overconfident.

CIRCLE OF COMPETENCE PRINCIPLE

Value investors make hardheaded 'assessments of their competencies. If they doubt their skill in stock selection, they steer clear. Value investors know their limits, thickly drawing the boundaries of their circle of com­petence. They avoid investment prospects beyond those boundaries as well as anything even close to the boundaries. This rules out broad seg­ments of industry, enhancing prospects and economizing on time and resources devoted to studying businesses. Those who cannot even iden­tify a circle of competence should avoid stock picking altogether.

For those who feel a need to allocate a portion of their wealth to stocks, choose vehicles other than individual stocks, such as mutual funds, index funds, or do so through a diversified retirement account. However, these operate as subparts of the broader market, and there­fore can be over- or underpriced. This means applying the same ten principles of disciplined investing, but perhaps less rigorously so.

MOAT PRINCIPLE

Market gyrations, price-value discrepancies, and risks of overconfi­dence warrant exercising extraordinary caution in selecting an investment. In focusing on the business, value investors ascertain whether the business itself is substantially insulated from adversity. Value investors avoid businesses threatened by product market downturns, recessions, competitive onslaughts, and technology shifts. The busi­ness itself must be fortified by a moat, a defensive barrier to these ill effects such as arise from brand-name ubiquity, staple products, mar­ket strength, and adequate research and development resources. Franchise value is exhibited by high, sustainable returns on equity.

MARGIN OF SAFETY PRINCIPLE

Value investors worry that they might be wrong when complying with these first five principles. So they add a belt in addition to these sus­penders. Drawing on the point that prices are different than values, value investors insist on as large a favorable margin of difference between them as possible. Doing so produces a margin of safety against judgment error. While none of these 10 principles should be ignored, this is the most fundamental and universal. Obeying this one promotes obedience to the others as well.

IN-LAW PRINCIPLE

The headline-grabbing accounting scandals of the early 2000s under­score the age-old importance of trust in investing. Value investors invest only in the stock of companies known to be run by faithful stew­ards of investor capital. They seek proven track records of good judg­ment and fair treatment. History is not always reliable, but any hints of malfeasance in a manager's record are enough to disqualify his employer. Value investors imagine managers of companies they are considering as prospective in-laws. If they would not want their child to marry a company's top manager, they don't invest money in that company.

ELITISM PRINCIPLE

Few stocks or other investments live up to these principles rigorously applied. Value investors treat companies as applicants to an exclusive club they run and wish to keep exclusive. It is far safer to make the error of omission than to make the error of inclusion. Those invited to join a value investor's portfolio after applying this elitist exclusion­ary policy can be invited often, more of their stock bought as circum­stances warrant. It is far more important to diversify across asset classes-having a savings account, some bonds, real property, and stocks-than it is to diversify across stocks.

OWNER PRINCIPLE

The cumulative effect of these principles is a characterization of the value investor's role in corporate investing as the owner of not just stock, but a business. Hence the principles of business analyst, moat, margin of safety, and son-in-law. It requires appreciating stock selec­tions in the same way the owner of a small business treats decisions concerning his store, farm, or firm. It requires a long-term view and means avoiding the rapid-fire share turnover characteristic of so many shortsighted market traders. That's what value investing is.”