Of the many different investing strategies that a modern-day investor may choose, value investing is among the most common. It is also the foundation of the Rule One investing strategy.
Let’s dive into what value investing is and how it differs from Rule One.
What is Value Investing?
Value investing is a strategy focusing on buying companies with a low price-to-earnings multiple. Ben Graham, Warren Buffett’s mentor, is the father of value investing and wrote the ‘bible of value investing, ‘Security Analysis,’ in 1934. That book is still in print today.
He called this ‘value’ investing because, ideally, each investment had more value than was paid in the price. In essence, the idea is to get $10 of value for a $5 price.
Graham thought that the best way to do that was to buy quite a number of cheap companies, typically about 200, to reduce the risk that any particular business was cheap for a really good reason, like it was about to go bankrupt.
According to Graham, a company’s stock was only underpriced – and therefore worth investing in – if it could be bought for below its liquidation value. The liquidation value of a company is determined by its net assets per share.
The underlying principles of this timeless approach persist to this day, but it was particularly effective during the Great Depression and World War II, the situation in the world while Graham was investing.
The Theory Behind Rule One Investing
By the time Warren Buffett started investing money, though, the economy had changed, and finding deeply undervalued companies was not as easy as it had been in Graham’s time.
So what happened?
To adapt, Buffett adjusted the theory somewhat, choosing to focus on finding companies that were not only undervalued but were also wonderful businesses with a highly predictable future. This required understanding the business, a process that necessarily limited the investor to a subset of the investing universe, what Buffett called your ‘circle of competence.
The Rule One strategy draws from this evolution of the classic approach to value investing to focus on great businesses that have a few, very specific qualities.
The Rule One view of value investing dictates that the best way to make large returns on your investments is to find a few intrinsically wonderful companies run by good people and priced much lower than their actual value. A business that hits all these marks constitutes a Rule One stock.
What are Rule One Stocks?
At its core, a Rule One stock is a stock that is priced lower than its intrinsic value. The problem is knowing what the intrinsic value is.
Intrinsic value is a term thrown around a lot regarding value investing. And that’s because it’s incredibly important.
Value investors often make decisions similar to what Ben Graham did, based on the business looking cheap, but Rule One investors know that it is better to buy a wonderful business at a fair price than a fair business at a wonderful price.
This is why Rule One investors require a deep understanding of the companies we invest in. We have to know the business well enough to know that it’s wonderful. I’ll teach you how to identify wonderful companies and determine their intrinsic value a little later on.
The Value Investing Mindset
There is a value investing mindset that is worth learning. Understanding this mindset is an important step in learning value investing. While it may not appear all that complex, buying $10 bills for $5 can be an emotional challenge, but these mindset tips will help you master it.
Fear is Your Friend
Buffett said that the secret to great investing results is to buy when there is fear.
Fear is what makes the market price of a wonderful business substantially lower than its value. In fact, fear is the only thing that makes the market price of a business wrong. Without fear around this business, industry, or economy, the business will not go on sale.
An old-school value investor decides when to buy based on a perceived low price and adjusts for the fear around this business by buying a lot of businesses so that no one business can ruin his portfolio.
But for a Rule One investor, fear is a friend because they understand the business, understand why the fear is there and have a conviction that it is irrational in the long run. Fear moves the market all the time, and if it isn’t justified, it could create excellent opportunities to buy stock in wonderful companies well below their value.
Focus on the Long-Term
Most big mutual funds are run by investors who consider themselves value investors. They talk the long game, but in fact, most big funds only hold stocks for 90 days or less. Rule One investors are actually long-term investors.
For example, I held one stock for 40 years. Rule One strategy is not a get-rich-quick scheme; it’s a buy-and-hold strategy. Once you find a company priced lower than its actual value, if it’s wonderful, you’ll want to hold it forever.
When operating as a Rule One investor, you need to be patient and keep your focus on long-term profits.
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