Back in the 1930s Benjamin Graham popularized the concept of Value Investing by stating a stock’s fundamentals and earnings were highly correlated with its price, but only over the long term.

Stock Market Investing the Warren Buffett Way

In the short term, fundamentals and earnings had very little to do with price.

Since that time many investors have used this concept to make billions and billions of dollars. Graham’s most famous student, Warren Buffett, went on to make over $65 Billion in the stock market using the lessons he learned.

Although Buffett didn’t use Graham’s exact strategies, he used the high-level concepts Graham taught to great effect.

In fact, Value Investing makes sense on a number of different levels. It is the only investing strategy that has risk management built in from the outset and it appeals to common sense.

Unfortunately most investors throw common sense out the window when it comes to the stock market. They like action. They prefer to run with the crowd. And they like the adrenaline rush they receive when they’ve put money on the line purchasing a highly touted hot stock hoping to get rich quickly.

And Wall Street loves that. The more people trade, the more money Wall Street makes. The more unsuccessful investors there are, the easier it is for Wall Street firms, mutual fund companies and the big banks to convince them to turn their money over to be “managed” by “professionals.” And the less people know about how to spot a company with strong fundamentals and wide economic moats, the easier it is for Wall Street to unload junk on oblivious investors.

Value Investing practitioners, on the other hand, prefer very little action. They go against the crowd and they’re happy when they get rich slowly over time – because they know it’s highly improbable to get rich quickly in the stock market. And they definitely don’t listen to people touting “hot” stocks.

If you’re wondering  why the most successful investors are Value Investors, it’s simple.

They buy low and sell high. And they only purchase the very best stocks with the most stable earnings so they have a far less chance of losing their money. Think of it this way, when you go to a grocery store, an electronics store or you’re looking for golf balls, do you buy more when the price is high and refuse to purchase when the price is low?

Of course you don’t.

Rather, you buy more at low prices and purchase less (or even refuse to buy) when prices are high. So why should it be any different with stocks?

Well, it shouldn’t. But unfortunately it is. I think the main reason is because the majority of investors don’t realize they are purchasing companies when they buy shares of a stock. And even those that do, don’t know how to value the company they’re buying. So they don’t know whether they’re paying too much, too little or exactly the right price.

Therefore they rely on what analysts and the other so-called, “experts,” are saying and they follow the uninformed crowd because they feel if everyone else is doing it, it must be right.

That’s certainly true for many things, however it’s very much untrue for stocks. If everybody is buying a particular stock, the odds are you should not be purchasing it – and if you own it, you should probably be selling.

Every stock has an intrinsic value. That’s the price it’s worth based on its underlying company’s performance and fundamentals. However a stock’s current market price might be below, at, or above its intrinsic value. The reasons are many. A stock could be overhyped and therefore its price is bid up far higher than its underlying worth. Or a stock could succumb to apathy, where people get tired of waiting for it move up and decide to sell, thereby dropping its price far below its intrinsic value.

Many times people get greedy and buy the latest hot stock simply because they think it will go up like a rocket. At other times they’re afraid and sell excellent stocks far below what they’re worth.

Despite what people will tell you, most aren’t rational or logical. They invest based on emotions, not logic. They give in to fear and greed and ignore the numbers. In the long run, that’s a sure-fire recipe for disaster.

Value Investing is the only truly logical investing strategy.

When others overreact and sell great companies because of fear or some analyst’s downgrade, Value Investors jump in and scoop up the bargains in much the same way careful shoppers scoop up bathroom tissue and toothpaste when these items are severely discounted at the local grocery store.

And when investors give in to greed and want to pay through the nose to purchase shares at double or triple what they should be selling for, Value Investors unload their holdings for nice, tidy profits.

They buy low and sell high using logic while others buy high and sell low using emotions.

That’s one of the key pillars of Value Investing. Buy companies for less than they’re worth. Significantly less.

Another pillar is to only purchase excellent companies. Some companies might look cheap but are not good buys. You don’t want to tie yourself to a company that has no future, declining earnings or is poorly managed. Such companies will eventually decline over the long term or go out of business.

On the other hand, great companies have a long history of stable and growing earnings. They’re well managed and, in many cases, pay a steady stream of dividends. Still, great companies can be expensive. In fact they usually are because they’re well known and lots of people want them.

However there are certain times when, for various reasons, people act irrationally and dump these companies thus driving their prices down. A smart Value Investor knows this is only a temporary situation. No matter what happens, you just can’t keep great companies down. They eventually bounce back. So if you’re able to purchase excellent companies for less than they’re worth, it makes sense to load up the shopping cart.

That way you own a great company with solid earnings and a wide economic moat and you purchase it at a price below market value. The difference between what the stock should be selling for and what you purchase it for is your margin of safety.

Benjamin Graham wrote quite a bit on the idea of margin of safety and Warren Buffett uses it religiously.

To see Value Investing in action, let’s look at the period from 1980 through 2010. The S&P 500 returned 11.2% per year on average. Which is a pretty good return. However if you ranked stocks by price-to-book-value and selected the lowest 30%, rebalancing each year, your return would have been 13.6% a year over that same period.

Value’s performance advantage was a whopping 2.4% more per year.

Of course price-to-book-value is a simplistic ratio that doesn’t take overall fundamentals or economic moat strength into account. Neither does it factor in earnings, dividends, management talent, market capitalization or a host of other important elements. So selecting stocks based on better criteria should increase the Value advantage.

Still, it’s important to remember that sometimes stocks are cheap because there is something fundamentally wrong with them. Just because a stock is cheap does not mean it’s a good value. Value Investors know this and only purchase the very best stocks selling cheaply.

So if Value Investing is so logical and profitable, why don’t more people use it?

That’s a good question, and the answer lies in something I’ve already touched upon. Most people invest with their emotions and they’re impatient. Sometimes it can take months or years for the market to realize a stock’s true value. And most investors don’t have the patience for that. They want to make money quickly (within a few days or weeks). They feel they have to be doing something and just can’t sit around doing nothing.

But doing nothing is one of the most profitable things you can do if you’ve correctly researched your stocks and purchased them with a sufficient margin of safety. And that’s why Value Investors inevitably end up with far more wealth than other types of investors.

There are no short-term traders sitting on the Forbes most-wealthy list, but Value Investors are well represented – including the most famous Value Investor of all – Warren Buffett.

So if you’re an investor with a long term orientation and you have the patience and logic to see where the real profits are, then taking a Value Investing approach is well worth the effort.

But make no mistake, it can be a taxing experience. When others are investing in garbage but making tons of money, such as we saw during the Dot Com bubble in the late 1990s, it’s tempting to lose patience and join them in chasing the hot stocks.

However this is an extreme form of market timing and when the good times end, they end quickly. And when everyone rushes for the exits, prices fall rapidly and usually wipe out a significant portion, if not all, of investors’ portfolios.

And that’s just what happened when the Dot Com bubble burst at the turn of the century. People lost lots of money and many were wiped out.

But people like Warren Buffett, who was severely criticized for not participating in the insanity, made out like bandits. Not only did they have lots of cash when markets crashed, but the panic and fear, so rampant when the bubble burst, pulled down the great companies along with the bad.

So fantastic companies like IBM, Coca Cola and Microsoft were trading for pennies on the dollar. Value Investors jumped in and scooped up these blue chip companies and waited. A few years later, when the good companies recovered, these investors were sitting on piles of profits. And Warren Buffett, who was ridiculed as a dinosaur, laughed all the way to the bank. And he’s still laughing.

If you want to invest successfully in the stock market you need to realize it’s a marathon, not a sprint. And as such you need to implement marathon-like strategies. You won’t win the race using short-term, illogical strategies in much the same way you won’t win a marathon training like Usain Bolt does.

So take a page from Warren Buffett’s book and invest the way he does. It’s your most probable path to investment riches.

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