A wise man said, "Price is what you pay for; Value is what
you get." This one sentence encapsulates the concept of
the value investing discipline.
Benjamin Graham, the father of Value Investing, and Warren
Buffett's mentor, extended this concept to the stock market
by illustrating the following parable. From Intelligent
Investor:
"Imagine that in some private business you own a small
share that cost you $1,000. One of your partners, named Mr.
Market, is very obliging indeed. Every day he tells you
what he thinks your interest is worth and furthermore
offers either to buy you out or sell you an additional
interest on that basis. Sometimes his idea of value appears
plausible and justified by business developments and
prospects as you know them. Often, on the other hand, Mr.
Market lets his enthusiasm or his fears run away with him,
and the value he proposes seems to you a little short of
silly.
If you were a prudent investor or a sensible businessman,
you would not let Mr. Market's daily communication
determine your view of the value of your interest in the
enterprise. You may be happy to sell out to him when he
quotes you a ridiculously high price, and equally happy to
buy from him when his price is low. But at the rest of the
time, you would be wiser to form your own ideas of the
value of your holdings, based on full reports from the
company about its operations and financial position."
Put another way, one must distinguish "quotational loss"
versus "permanent loss of capital". The former is movement
in the price of a stock due to psychological sentiment,
liquidity issues or other factors. The latter is a
"permanent damage" to the franchise of the business due to
fundamental factors - such as product obsolescence,
permanent changes in market demand for a product, losing
market share to a better competitor, changes in the habits
of customers, upcoming product substitutes.
This all sounds simple. But it begs the question: How
does one know if the value of a business is changing? The
answer is not to look at the stock price, but to do your
own research. For example - try the product, visit the
store, read business and trade magazines, or ask friends
who are customers of the business. The other way is to
gather facts and data points about the financial state of
the business.
The internet is a great way to do fundamental research on
stocks. You can go directly to the company's SEC Filing,
pick up a chart, news headlines, get analyst's estimates
and ratings, earnings history, financial statements and
many more. You can also do market research on government
web sites and other trade association web sites. Finally,
if you have the time, you can participate in many active
communities and discuss with others about a product, a
stock, etc.
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