This chapter is dedicated to describing the philosophy of value investing and why it works. The terms used to describe value investing don’t require any accounting or finance background, making this an easy read for beginners looking to learn about value investing.
Value investing is described as paying 50 cents for a business worth $1. Warren Buffett’s analogy using the maximum allow
able weight of a bridge is used to illustrate how this margin
of safety works:
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
What allows value investors to apply a margin of safety while most speculator
s and investors do not? Again Klarman uses a Buffett analogy to illustrate this:
A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.
As a result, Klarman asserts that value investors do not buy businesses they do not understand, nor ones that they find risk
y. For example, they will avoid technology companies and commercial banks. Value investors will also invest where their securities
are backed by tangible assets, to protect them from downside risk.
Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business. The margin of safety (buying at a discount) is therefore of utmost importance. Since institutions do not buy with a margin of safety, remain fully invested at all times, and trade stock
s like pieces of paper with little regard to the underlying
asset values, value investors gain an advantage.