The Business of Value Investing.pdf

Establish a Sound Investment Philosophy 61

a year in interest and has a face value of $ 10,000, it yields 5 percent.

If interest rates for similar bonds are 5 percent, investors will be

willing to pay $ 10,000 for the bond. Since 5 percent is the current

yield in the market for similar bonds, by paying $ 10,000, the inves-

tor is not overpaying for bond. However, if the price of the same

bond is more than $ 10,000, then the investor will not be getting a

5 percent yield and should choose another bond. There is certainly

more to bond pricing, but the general idea is that relative to stocks,

bonds are relatively straightforward to value. And during environ-

ments of unprecedented fi nancial turmoil, such as 2008, valuations

simply do not seem to matter, so any attempt to value a business

seems worthless. Still, the ultimate driver of value is the amount of

cash produced by business after all other needs and bills are paid

(the free cash fl ow). A business that continues to generate cash

ultimately will become more valuable. But in the short term, stock

market prices are affected by the votes of market participants, not

by business fundamentals. Over time, the stock market becomes

a weighing machine where valuations are infl uenced by business

attributes. Unfortunately, when markets are in crisis mode, the mar-

ket can vote for a very long time.

Avoid Using Margin

As a value investor, your goal is to participate in investment oppor-

tunities where the probability of a gain exceeds the probability

of loss by the widest possible margins. You devote serious time to

analyzing the business, assessing the quality of management, and

rationalizing what the business will look like into the future. These

efforts require time and painstaking effort. In short, the goal of

value investors is to skew the odds very heavily in their favor toward

the number - one goal: preservation of capital. This mentality often

is referred to as focusing on the downside while letting the upside

take care of itself.

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