What would you pay for a gallon of milk? Would you pay $2? $3? Would you pay $4? What if it was very popular milk, and everyone was buying this particular brand of milk? Would you then be willing to pay $5 for a gallon? No?
Why not? Because milk at $5 is overpriced–it’s a bad value. Stop and think about it–why is milk any different from stocks? A stock is not a piece of paper that has no true value that is meant to be traded back and forth among a group of people acting like manic-depressive lemmings. A stock is part-ownership of a company. Companies, like the goods you buy at the grocery store, have a true value.
It is true that companies are more complicated than milk; however, they still have a fair value that can be calculated. Actually, in some ways, companies are simpler to value than milk, because we can measure and attempt to predict the profits they produce and the assets they hold. Measuring the benefits that milk gives us, on the other hand, can be quite hard.
If you agree with what I have just said about the possibility of calculating (albeit approximately) the fair value of a company, then you are well on your way to being a successful value investor. The secret to value investing is this: find a company that is being sold below its true value and then buy it.
It is incredibly simple, and its simplicity puts all of the stock market hucksters to shame. There are many investment newsletters that claim to be able to help you achieve spectacular gains quickly. Their cachet is the complexity of their methods. (See, for example, the Delta Society.) However, the complexity of their methods keeps you from understanding them and deciding for yourself whether they actually work. I’ll admit that some methods of speculation may actually work. However, even the methods that work have large risks, and you can lose a lot of money really quickly. Why not use a simple system that you can understand, a system that works, and a system that you can use without a PhD or 30 hours a week studying, without having to pay for expensive seminars or thousand dollar per year newsletters?
The only thing that is difficult about value investing is that it is not for those who lack ‘intestinal fortitude’. Value investing will often call for buying a stock precisely when everyone else is screaming ‘sell!’ Value investing often requires buying unknown companies in unglamorous business. Value investing will often involve buying stocks that are selling at all-time lows, rather than all-time highs.
Therefore, in value investing, you will not sell a stock just because its market price has gone down (nor should you sell it just because the price goes up). If the price of a gallon of milk goes down, the milk is an even better value. Therefore, you would buy more (up to a point). Likewise with stocks, if a good company is available for half as much, it is twice the value. The only situation which would change that would be if the company’s business were to start deteriorating. Just as you avoid paying any amount for sour milk, you should avoid paying any amount for a bad company (or, at the very least, pay very little and only do so if you are confident the company can turn itself around).