Bio: Andrew Sather, founder of einvestingforbeginners.com, uses past bankruptcy data to minimize downside risk– only buying with an adequate margin of safety, sound balance sheet, and long term growth. He teaches value based ratios in his free stock market PDF.

Like most things investing, it seems like I am constantly taking a contrarian approach. Value investing, at its core, is based on comparing a company’s fair market value with the way you’ve calculate its intrinsic value and closing that gap. Graham, Klarman, and others call it a margin of safety.

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margin of safety focus

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By closing that gap, I mean waiting for the company’s share price to catch up with its intrinsic value. Buying with a margin of safety simply means buying a stock at a discount to its intrinsic value. The thought is that emotions and perceptions on a company are temporary, and stocks out of favor in the market will eventually trade back at its intrinsic value over the long term.

An approach like this actually lowers the risk rather than increases it. You get less exposure to risk because the more of a discount you get, the less likely it is the share price will decrease further.

Because although many see the market as a voting machine, where all it takes is to buy stocks before they get popular, prudent investors see the market as a weighing machine—with an underlying business behind it. Analyze the business, not the share price potential.

A major risk to buying depressed stocks is that many will have pessimistic views on themselves precisely because their business is struggling. A more complete overview is needed to ensure that isn’t the case.

The danger in relying on a particular intrinsic value calculation is that most intrinsic value calculations only concern themselves on a focused portion of the financial statements.

That’s exactly why I take an approach to span all 3 financial statements in my “buy low” approach. To me, it’s like the difference between security cameras all around your house vs. just one high powered 4k HD camera at your front door. Many value investors place their one narrow viewpoint HD camera and think they are protected with their calculated margin of safety.

Now, back to the matter at hand.Inline image

The discussion of when to sell is always a sticking point. Opinions on this are like a personality, everyone has one. I’ll admit it’s hard to come up with hard and fast rules for it, though I’ll argue it’s important to do just that. You must have an exit plan in mind or else you’ll always feel uncertainty or regret.

Obviously I jive well on many discussions I have with value investors. Talking to them is like finding someone with the same politics or religion as yourself, an instant brother from another mother.

A sound philosophy like value investing takes away much of the uncertainty and confusion about the markets, providing solutions for particular situations and creating passion and comradery between people with the same goals and viewpoints about how to achieve those goals. It’s based on finding an edge—in this case, a margin of safety—and implementing it to hopefully outperform the market.

Now, when you get deep enough down the rabbit hole, there will inevitably form different niches of value investors. A central thesis like a margin of safety works so well because its implications are broad but applications can vary.

There also forms debates on the details.

When such a dissonance occurs, many value investors just look to an expert and follow exactly what their viewpoint is. I vehemently disapprove of doing this.

I believe the beauty of value investing is that while the basic idea remains the same… the market always evolves and so your ideas need to evolve with them. What Buffett did 20 years ago and what Graham did 80 years ago won’t exactly work today on the same scale—if only because many copycats are trying to do just that all the time.

For example, I don’t get too caught up in Graham’s hard fast rules of P/B below 1.5 and P/E below 25. While useful and preferable for many stocks, I don’t see it as required.

Consider that the U.S. economy used to be a manufacturing economy. It was more asset intensive. Low valuations are important, but they become less so as the general market rises. I craft my approach around the idea that it’s not the low valuation that’s important, but instead avoiding the high valuation.

The difference between a P/B of 1.5 and 2 is mostly insignificant, while any P/B over 5 becomes increasingly concerning.

Ok.

Value investors agree on buying at a discount to intrinsic value.

But some are steadfast in their belief that you should sell once that company’s stock price reaches its intrinsic value. After all, Graham/ Buffett advocated this in the “cigarette butt”, net-net investing style.
So, many investors read about this and just follow along. I think it’s a grand mistake.
What matters is price paid, not current price
I guess you’d call it an opportunity cost thing, right? I mean sure it makes sense, in a perfectly logic and rational world, a stock trading at fair value and no discount to intrinsic value should perform sub optimally to a stock at a discount.

So, the value investor moves the money away from his winner and back towards a new, flashy opportunity. Realize the profits and reinvest them. I get that.

But I think there’s a massive overconfidence that comes with this approach. Whether you like to admit it or not, it’s not easy to find a winner every time. Not every stock reaches its intrinsic value, especially with your own personal brand of its calculation.

The market isn’t always perfectly logical and rational either. After all, that is what is creating our opportunity in the first place. Momentum is something that shouldn’t be ignored.

A stock that finally reaches its true intrinsic value finally has price momentum on its side—and price momentum can carry a stock higher than you’d expect. Selling at this point is like cutting the small and fast growing tree out of your overcrowded backyard. You should be chopping down the small and sickly trees, not the ones growing out of their small hole of sunlight.

Either two things have happened: the market sentiment has finally changed from pessimistic to optimistic, the business model has finally turned around, or a combination of both.

Why you wouldn’t want to ride those events out as long as possible is a mystery to me.
It’s dividends that count, not share price
Again, I take a somewhat contrarian value investing approach in the sense that I put a big priority on dividends. I don’t understand the disconnect on why this gets lost.

I think that value investors get so excited by their new viewpoint that they throw caution to the wind and forget about some of the biggest basics—such as long term investing and dividend compounding. It stems from an irrational overconfidence, thinking nature’s laws don’t apply because they have the superior method.

The whole point of my investing is to create passive streams of income for myself.

I understand that the results of my investments will fluctuate, and the only thing that will stay consistent is the income I receive from them, as long as I am watching these investments and ensuring the reliability of the dividend payments.

The best form of compounding in the stock market is the compounding of the dividend. When you buy a growing dividend stock, you get an increasing stream of income every year. When you also reinvest the dividend, you increase your income even further.

So the dividend payment naturally compounds because the company is doing this as a positive result of their growing business/ earnings, and your reinvestment adds another form of compounding.

Buying these dividend stocks at a discount to intrinsic value just further improves the results, leading to even higher growing rates of compounding compared to just buying growing dividend stocks at high(er) valuations.

Long term investing depends on not selling
It’s funny. Value investors have no problem understanding the value of holding long term when it comes to waiting out a company’s troubles until things turn around.

Yet when it comes to letting an investment naturally compound to success, this breed of value investors tries to control the compounding themselves and constantly find better opportunities. Not only is this work intensive, but again it’s arrogant and controlling.

The magic of stock ownership is in the idea that you are purchasing part of a business. You buy at a fair price, and the business does what successful businesses do. Compound and grow earnings to grow assets, to grow earnings, to grow cash to shareholders—dividends.

When you sell too soon, you put more of your results in the hands of your investing prowess and ability to find discounts rather than in this natural phenomenon of business. How long can you defy nature’s laws?
Sure, you might see better results in the short term, but what about over the very long term?

If you consider that the very best businesses have been able to return  17% a year back to shareholders for 25 years, or that companies have been able to turn $10,000 into $500,000+ through long enough periods of dividend growth and reinvestment… why wouldn’t you want to be a part of that.

There’s seasons for everything in the market. There’s times when value investing outperforms the market, and times when it underperforms. I can see why it’d be easy to be gung ho when you’re doing this and outperforming for a short time.

But what happens when value stocks are getting pummeled? How does this affect your results over the very long term? How many discounts will you have to find to recover?

I don’t have the data to answer that for you, but I’ll bet the answer isn’t favorable for you if you prefer to sell a stock once it reaches intrinsic value. I could go on about this more, but let me step back instead. I’ll stop trying to control everything and let things naturally develop—see what I did there?

The author doesn't hold any securities that may be listed.