Learning the Basics of Value Investing
Learning how to buy stocks according to the principles of value investing is relatively simple. The only requirements for a successful value investor are the ability to determine what a company is worth and the right psychological approach to stock prices, which involves recognizing hope (AKA enthusiasm or greed) and fear.
The concept of "Mr. Market," the famous metaphor for the stock market created by Benjamin Graham, the father of value investing, can help you with that second important skill. It will forever change the way you look at stock prices and, if employed correctly, increase your investment returns noticeably.
Enthusiasm and Fear in One Market Metaphor
In his classic book, The Intelligent Investor, Graham captured the highs and lows of the stock market in one often irrational business partner.
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Freedom of Choice
The best parts of this entire metaphorical arrangement are: 1) you are free to ignore Mr. Market if you don't like his price and 2) he will always offer you a new price on the next trading day.
As long as you have a strong conviction about what the company is really worth, you will be able to astutely accept or reject Mr. Market's offers. The choice is always yours. And all the while, you should understand, the underlying value of the company may not have fundamentally changed—only Mr. Market's mood has.
If you find he is feeling gloomy and offering his stake in a company for less than it is worth, take advantage of him and load up on shares.
Sure enough, as long as the company is fundamentally sound, Mr. Market will be feeling overly hopeful one day and will offer to buy the same stake back from you for a much higher price.
By thinking of stock prices as offers from an emotionally unstable business partner, you can free yourself from the emotional attachment most investors feel toward rising and falling stock prices—and from the sometimes irrational decisions that emotional attachment can lead to.
Before long, when you are looking to buy a stock, you will unemotionally welcome falling prices. And you will unemotionally invite rising stock prices when you are looking to sell your existing securities.