Main theories of value investment

1. Benjamin Graham’s value investment theory

Benjamin Graham graduated from Columbia University, USA, and ever served for Columbia University Business School as professor. He is the founder of the value investment theory and Buffett’s teacher. Graham mentioned the value investment theory for the first time in book Securities Analysis published in 1934, and comprehensively expressed the basic ideology for the initial value investment in book Clever Investors published thereafter:

1. Relationship between the stock price and intrinsic value of a stock

The intrinsic value of a stock is the precondition for investment. When the stock price is lower than the intrinsic value, the investor shall consider to buy, otherwise, to sell. Fluctuation of the stock price is caused by the investors’ bounded rationality, such as greed, timidity, prejudice and restraint in acquiring information, and so on, so the intrinsic value of a stock is different from its current market trading price, an investor shall buy the shares when the market price is obviously lower than the intrinsic value obtained through calculation and assessment, in this case, definitely, he will receive an excessive return at the end. How to assess and calculate the intrinsic value of a stock? Graham thinks that the key to calculating the intrinsic value of a security is not to determine its precise intrinsic value, but to understand that the intrinsic value is a concept which is hard to comprehend. Generally speaking, the intrinsic value refers to the value based on the assets, earnings, dividend and clear prospect. It is necessary to find out whether the intrinsic value is high enough to provide a safe space as compared with the trading price in other markets; Graham thinks that the intrinsic value is a concept hard to comprehend. Generally speaking, the intrinsic value refers to the value based on the assets, earnings, dividend and clear prospect, and is different from the market price disturbed by artificial manipulation and mental factors. Through observation, Graham thinks that the market price of a stock often deviates from its intrinsic value, and when this deviation takes place, the market will tend to correct this deviation. Graham has provided a basic approach to estimate the intrinsic value of a stock, namely, firstly, predict the average revenue in the coming years, then, determine the intrinsic value of the stock with a capitalization rate.

2. Safety margin

When making investment, it is necessary to pay attention to the buying price of a security, and the safety margin, thus to provide a sufficient safe space between the buying price of the stock and its intrinsic price. The so-called “the safety margin” means that the investor shall calculate and evaluate the intrinsic value of the stock, then, compare it with the trading price of the stock, and invest on and buy this stock when the calculated intrinsic value is higher than the trading price by a certain level. Obviously, the lower the stock price and the higher the intrinsic value, the lower the risk is, so the higher the safety margin of the stock to be bought is, in this case, the investor can receive high earnings at a low risk when holding this kind of stock. If the trading price of the stock is only slightly lower than its calculated intrinsic value, the investor shall wait and not buy it in a hurry; only when the stock price is greatly lower than its intrinsic price, for example, by 50% or even more, this stock is undervalued substantially by the market, so the investor may have a bigger safe space even if the calculated intrinsic value is not precise.

The “safety margin” is the core of Graham’s investment methodology, and the intrinsic value is the base for foundation investment. In order to use the safety margin method properly, the investor shall know some methods to estimate the intrinsic values of companies.

3. Negation technical analysis

The intrinsic value of a stock can be understood and comprehended only analyzing the “actual” data in the financial statements of the company. It is hard to know the qualities of the management of the company and effects of the industry on market variation.  Graham’s proposed his securities analysis method for quants in value investment for the first time, which concerns on the intrinsic value of the company. He is the first person who pointed out that the emphasis for securities analysis is to calculate the intrinsic value of the stock and measure the size of the “safety margin”, meanwhile, make rational judgment on the corporate governance, such as the accounting system, management, capital structure and dividend policy, and so on, of the company, all of which are the important supplementary information for making decisions on investment.

This article is excerpted from “Series Publicity Brochures for Protecting Investors” edited by Tianjin Securities Association under sponsorship of CSRC Tianjin Bureau. We hope that this article can direct the investors to establish correct investment concepts and intensify their risk prevention consciousness.