INTRODUCTION TO VALUE INVESTING

IIM Ranchi
March 16, 2015

We think the very term value

investing is redundant. What is
investing if it is not the act of seeking
value at least sufficient to justify the
amount paid. Consciously paying more
for a stock than its calculated value
in the hope that it can soon be sold for
a still-higher price should be labeled
speculation (which is neither illegal,
immoral nor in our view
financially fattening). Warren Buffett

An investment operation is
one which upon thorough
analysis promises safety of
principal and a satisfactory
return. Operations not meeting
these requirements are
speculative. Ben Graham

Three Key Principles of

Investing

Principle # 1: Investor should

look at stocks as part
ownership of a business.

Principle # 2: Investors should

look at market fluctuations in
terms of Grahams Mr.
Market example and make
them your friend rather than
your enemy by essentially
profiting from folly rather than
participating in it.

Principle # 3: The three most

important words in investing
are margin of safety, which
means always building a
15,000 pound bridge if youre
going to be driving 10,000
pound trucks across it.

When you build a bridge, you insist it can carry 15,000

pounds, but you only drive 10,000-pound trucks across
it. And that same principle works in investing.
Warren Buffett

The Idea of Margin of Safety is based on the idea of

Redundancy in Engineering
http://en.wikipedia.org/wiki/Redundancy_(engineering)

Sources of Margin of Safety

Margin of Safety From A Low Price

In American roulette there are 38 slots

numbered 1-36, 0, and 00. Pay-out is 35:1

If you bet Re 1 on your lucky # 8 and if the

ball lands on # 8, you win Rs 35, otherwise you
lose Re 1.

You wager Rs 1,000 on a single number, say number 7.

Probability of ball landing on 7 = 1/38 = 2.63%.
Probability of not landing on 7 = 37/38 = 97.37%

Event
Ball lands on 7
Ball does not land on 7

Payoff

Probability Expected Value

36,000

2.63%

947.37

97.37%

0
947.37

Amount Bet

-1,000

NPV

-52.63

Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38

numbers to spread your risk

Event
Ball will land on one of
your numbers

Payoff

Probability Expected Value

947.37

100%

947.37

Amount Bet

-1,000

NPV

-52.63

Lesson: Diversification does not work when Margin of Safety is

absent.

Each bet has an expectancy of a profit even though

some will inevitably result in a loss
Wide diversification
Cap on Max Bet

Four Businesses

Some Principles
Principle # 1: Assets are worth more than book value
when they are expected to earn a return on capital
employed which is more than market rates of return.
And Vice Versa.

Some Principles
Principle # 2: Assets lodged in the hands of a manager
who thinks and acts in the interests of the owners are
worth more than identical assets lodged in the hands of
a self-interested manager.

Some Principles
Principle # 3: All growth is not good. There is good
growth and there is bad growth. Good growth creates
value. Bad growth destroys it.

Some Principles
Principle # 4: Quality matters.
Leaving the question of price aside, the best business
to own is one that over an extended period can employ
large amounts of incremental capital at very high rates
of return. The worst business to own is one that must,
or will, do the opposite - that is, consistently employ
ever-greater amounts of capital at very low rates of
return. Warren Buffett

Some Principles
Principle # 4: Quality matters.
The worst business of all is the one that grows a lot,
where youre forced to grow just to stay in the game at
all and where youre re-investing the capital at a very
low rate of return. Warren Buffett

Some Principles
Principle # 4: Quality matters.

"Time is the friend of the wonderful business, the

enemy of the mediocre.

Some Principles
Principle # 4: Quality matters.

"If a business earns 18% on

capital over twenty or thirty
years, even if you pay an
expensive looking price, you'll
end up with one hell of a
result." Charlie Munger

Some Principles
Principle # 5: Price Changes Everything
Leaving the question of price aside, the best business
to own is one that over an extended period can employ
large amounts of incremental capital at very high rates
of return. The worst business to own is one that must,
or will, do the opposite - that is, consistently employ
ever-greater amounts of capital at very low rates of
return. Warren Buffett

(Compound Interest + Longevity) + Reasonable price =

Wealth Creation
Key Questions:
What produces (Compound Interest + Longevity)?
What produces Reasonable Price?

Various Sources of Moat

Intangible Assets
Customer Switching Costs
Network Effects
Low Cost Advantage
Niche
Corporate Culture
Reputation

It is useful to think about moats from the perspective

of customers as well as competitors

(Compound Interest + Longevity) + Reasonable price

= Wealth Creation
Key Questions:
What produces (Compound Interest + Longevity)?
What produces Reasonable Price?

The capital asset pricing

model type reasoning with its
different rates of risk adjusted
returns and the like, we
consider, it nonsense.

But we think its also nonsense to

get into situations or to try and
evaluate situations where we
dont have any conviction to speak
of as to what the future is going to
look-like. I dont think that you can
compensate for that by having a
higher discount rate and saying,
Well, its riskier. And I dont really
know whats going to happen.
Therefore, Ill apply a higher
discount rate."

SUMMARY
All investing is value investing but there are three key principles
to follow. (1) Business Underneath Every Stock; (2) Mr. Market
can be Wrong; and Margin of Safety is Important.
A Fundamental Principle: (Compound Interest + Longevity) +
Reasonable price = Wealth Creation
Investors Should Spend Time Understanding the Above Equation.

Thank You
Sanjay Bakshi