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Unveiling the Mystery: Value Investing – Beyond Methods and Labels

Even on the lesser-traveled path of value investing, there are many philosophical differences. Recently, after reading Chen Jiahe’s new book “Understanding Investment”, I have more thoughts on some basic issues of investment. I have known Brother Golden Harvest for a long time and had a good conversation, although our investment methods are not the same, but there is no difference in the understanding of investment and the underlying philosophy, on the contrary, the collision of views from different perspectives will bring a lot of inspiration to each other.
What exactly is value investing?

Value investing was first proposed by Graham in the 30s of the last century, and after nearly a century of evolution, its connotations have become richer and richer, and the investment methods have become more and more diverse. There are also many methods in China for investors to chase high-growth strategies, high-dividend strategies, and “undervaluation, diversification, and lack of deep research”.

No matter how the “shape” of value investment changes, value investment will eventually fall on the word “value”. The price is what you pay, and the value is what you get. Buying an investment at a price lower than its value or an investment that can increase its intrinsic value at a market price lower than its intrinsic value belongs to the category of value investing – this is the “god” of value investing. To grasp the “god” of investing, we must first recognize the first principle of value investing: a stock is essentially a part of the ownership of the business it represents, and the value of a stock is created by the company behind it.

How to judge the intrinsic value of an enterprise, different schools have different standards. One view is the effective net asset value, and the other is the total cash flow value that can be created in the whole life cycle of the enterprise, and the latter view is that there are many assets that create cash flow that are not reflected on the books, but are more decisive things behind the cash flow, such as brands, monopolies, network effects, etc. This difference in perspective has created two very different schools of investment, Grignard and Paktoul.

Correspondingly, there are two main types of valuation methods: one is based on liquidation value or balance sheet; The other is based on discounted future earnings or free cash flow. Here we ignore those valuation methods that are based on Mr. Market. The valuation method based on liquidation value can be broadly referred to as the asset value investment method, which can usually cover some methods similar to cigarette butt investment, “undervaluation, diversification and lack of deep research”; The earnings or free cash flow based valuation methodology, which we call the earnings value investing approach, also covers most growth stock investment strategies.

From the perspective of the comparison of these two investment methods, the margin of safety of the asset value investment method is reflected in the book value discount, and the margin of safety of the profit value investment method is based on the judgment of the future income of the enterprise. The asset value investment method emphasizes that “you will make money when you buy”, and the profit value investment method is to make money for the future growth of the enterprise, so from the perspective of the holding period, the asset value investment method is usually sold at a price, and may be sold at any time, and the profit value investment method often holds the stock for a longer time. From the perspective of thinking mode, the asset value investment method admits that it is very difficult to predict the future, and the purpose of leaving a sufficient margin of safety is not to worry about predicting profits, which is a kind of weak thinking that does not lose first and wins in the present, while the profit value investment method investors strive to go deep into the fundamentals of the enterprise and try to read the password of the company’s free cash flow, which is a kind of strong thinking that lets go of the present and wins in the future, so the asset value investment method is more dispersed, and the profit value investment method is often more concentrated.

Regardless of the investment method, it follows the underlying investment principles: Equity Thinking, Margin of Safety, and Mr. Market. In investment practice, the replicability of the asset value investment method is stronger, and it is not difficult to find companies that are significantly lower than the tangible net assets. Profitable value investing is more difficult to learn because predicting the future is already very difficult, and the essence of this investment method is to pursue higher certainty.

There is no such thing as an investment approach, and the choice of investment method depends not only on what you are better at, but also on whether you are more willing to stay with good companies or increase your value through trading.
Most of the controversy stays on the “shape”.

Now that we have seen the essence of value investing, let’s look at the debate surrounding value investing:

Long-term vs. short-term. First of all, as mentioned earlier, the asset value investment method is not long-term investment oriented. Secondly, the moat investment theory holds that “since buying stocks is buying ownership of the company, the intrinsic value of the enterprise is determined by its ability to generate cash flow, and buying equity is to hope that the company will create more cash flow returns for us during the holding period”. However, long-term investing is neither part of a moat investment approach nor the goal of value investing, and holding for the long term is just a common consequence of many successful investments. When we choose those good assets that can stand the test of time, we also need to continue to track and evaluate the ability of these assets to generate cash flow, that is, investment is a continuous decision-making process, and long-term holding is just the cumulative result of “continue to hold” decisions again and again. At the same time, investment is a capital allocation activity based on the comparison of long-term returns and risks, and the opportunity cost will affect the investment duration. The opportunity cost for investors is constantly changing, and when an opportunity with a rating of “better” arises, we forgo the opportunity with a rating of “good”, regardless of how long the opportunity has been held at that time.

Centralization vs. decentralization. Theoretically, if the principle of “always compare” is followed, the vast majority of companies will be excluded, and investment will eventually be directed to one or a few really good companies. However, in practice, uncertainty blocks the process of this comparison, and it can be said that diversification is to make up for the lack of certainty, and whether to concentrate or diversify is mainly related to certainty. Because people’s circle of competence is limited and the confidence level of the company’s performance predictions is not high enough, comparisons between companies are often specious, and moderate diversification is the best strategy for most people. It is advisable to establish a coordinate system with the abscissa as the prediction confidence level of the investment target, and the vertical axis as the investor’s research ability, when an investor with a high endowment encounters a high-certainty investment opportunity, that is, he is in the first quadrant, and it is not impossible to be absolutely concentrated at this time, and so on in the second quadrant can be relatively concentrated, the third quadrant can be relatively dispersed, and the fourth quadrant must be absolutely dispersed. In addition, concentration or diversification is also an active choice in terms of strategy, Buffett from the early relative diversification to relative concentration, but the strategy of different periods before and after can make money, but in comparison, concentrated investment needs to bear a higher degree of volatility.

Value & Growth. From a valuation perspective, it doesn’t make sense to divide companies into “value stocks” and “growth stocks.” From the perspective of the profitable value investment method, what is related to the value of the enterprise is the ability of the enterprise to generate cash flow in the future. If the enterprise has a good ability to grow, it must increase its intrinsic value, so we can say that growth is only a part of the value, but the important premise of this assertion is that this growth has a high degree of certainty, otherwise it is meaningless to discuss the impact of growth on value. Another common “pseudo-growth” problem in the discussion of value and growth is that high growth expectations in many industries rely on large capital investments, but do not lead to more free cash flow growth in the future. Only high growth that leads to high ROE and abundant cash flow, with only a small capital investment, can significantly increase shareholder value. So essentially, mainstream moat investments only need to focus on future cash flows and discount them at an appropriate discount rate, without differentiating between value and growth.

All of the above controversies are nothing more than the “shape” of value investing. Those who are obsessed with pursuing a better method of value investment are like asking who is the authentic martial arts in the world – Mr. Jin Yong’s answer is “the great man of chivalry, for the country and the people”, rather than looking at who has higher kung fu in Shaolin Wudang. As Graham puts the definition of investment to the point, “Investment is an operation based on detailed analysis that guarantees the safety of principal and satisfactory returns, and all operations that do not meet this criterion are speculation.” ”

No matter how the “shape” of value investment changes, it will eventually fall on the word “value”. The price is what you pay, and the value is what you get. Buying an investment at a price lower than its value or an investment that can increase its intrinsic value at a market price lower than its intrinsic value belongs to the category of value investing – this is the “god” of value investing.

To grasp the “god” of investing, we must first recognize the first principle of value investing: a stock is essentially a part of the ownership of the business it represents, and the value of a stock is created by the company behind it.

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