Human mind is amazing in its capability to create models and we can try to understand Value Investing through the concept of Models.
What is a Model?
A Model is defined as “A hypothetical description of a complex entity or process”.
In our context, the entity is Stock Market or the process is investing in Stocks.
Now don’t be alarmed by the term complex here. The nature of entity need not always define the nature of Model that can help us understand it.
Another important thing to note is that most of the times a Model cannot explain all the things about the entity and focus only on some aspects of it.
So we need to have a clear distinction between what a Model CAN do and more importantly what it CAN’T do.
Let’s try to understand “Value Investing” as a Model that we want to use to explain the investing in stocks.
Main thing to remember is that it’s just a Model like the numerous others.
Which brings us to another question:
Why we want to consider “Value Investing” Model instead of other Models?
The main USP of this Model is Simplicity.
Value Investing does not try to predict the timing of stock market prices. It only helps to buy at a bargain and then waits for the Market to inevitably move towards “Intrinsic Value”.
“Intrinsic Value” is nothing but the fair,optimum value for a business that is supported by some quantifiable aspects of the business.
The “Intrinsic Value.” is determined using methods that produce a fuzzy but very important benchmark.
Now, “Intrinsic Value” calculation is important…. But and that’s a BIG BUT…. The more important thing is to understand that ….It’s NOT the level of accuracy of “Intrinsic Value” that makes the core of Value Investing but the concept of having a “Value” as a benchmark. …..This distinction sometimes is very hard for people to grasp.
Simplicity is just a matter of taste. Some like it complex and some like it simple.
Though added complexity could make the model more accurate but that’s not always the case and most of the times it does not worth the efforts.
To accommodate this possibility of error in calculation another important concept in Value Investing Model is that of “Margin of Safety”….which just states that you only buy at the maximum distance possible from intrinsic value.
“Margin of Safety” is embodiment of the concept of giving up the accuracy for the sake of simplicity and at the same time maintaining the effectiveness of the Model.
A Value Investing Model just boils down to…”You just have to be good at only one thing… and that is identifying mispriced businesses.”
This involves understanding the fundamentals of the business and doing some relatively simple math related to the performance of the business.
We’ll explore more…Stay Tuned.