Value Investment, How Buffett made his billions?
Updated: Mar 20, 2021
When we're talking about value investment, we cannot help but talk about one of it's biggest promoter, Warren Buffett!
As one of Benjamin Graham's star student, Warren Buffett is the greatest speaks person for Value Investment.
What is value investment?
Before I explain what it is, I would like to tell you what it is not.
Value investment does not care about the short term high or lows of the stock.
It does not care about MACD, Bollinger Band, Stochastic Oscillator, RSI and any other Technical Analysis data.
VI focus on the fundamentals of a stock. Such as, how much does this company actually worth(Book Value), and was the price low or high based on the current market condition.
In the 1970s, When Buffett decided Berkshire Hathaway's stock price was low, based on it's P/B ratio.
One of the way Buffett used to justify buying Berkshire Hathaway is called Bankruptcy estimation. Which means, if a company's P/B(price per book value) is below 1.0, it is then trading at a discount. on the other hand, if a company's P/B is at 1.0, that means it's market value is equal to it's Total Book value.
P/B = 1.0 Means Market Price = Total Book Value
P/B = 0.5 Means Market Price < Total Book Value
P/B = 3.0 Means Market Price is 3x Total Book Value
Total Book Value (including intangible assets like Brand /Good will / Customer Base)
If we sell all the assets in the company that have a P/B of 0.5, you would have a 50% gain because the market price is at a 50% discount.
On the opposite, if we bought a company with 3.0 P/B and it went bankrupt, we can only get back 33.3% of the money invested.
If your head is spinning already, you are not alone.
Let me clarify!
If we bought any company with a P/B of less than 1.0, we'll make money, even when the company goes bankrupt and sell everything for cash. (at least in theory...)
Everything looks nice and well in theory, but soon, even Buffet realized how wrong he was after he bought Berkshire Hathaway below 1.0 book value.
Berkshire, at the time was a textile company, a manufacturer of clothing and linens. The business was not doing well, and losing money every year.
After Buffet took control of the company, he made many changes to try and reduce losses, but he couldn't revive the company.
Buffet soon realized if the company goes bankrupt, selling of the machinery, inventory, and other assets does not even get close to the book value...
The Book Value is actually the value of the assets, not how much they can really sell it for.
In a bankruptcy situation, most of the assets like machinery and inventory are sold at a large discount.
Although Berkshire Hathaway wasn't a total loss in the end, Buffet still loss money in the investment.
So, P/B valuation doesn't work?
Yes and No! Let's not jump to conclusions yet!
In a company with hard assets like manufacturing company, retail, agriculture or anything that contains large amount of heavy assets, PB valuation doesn't work. However, it works perfectly on financial institutions!
In companies such as banks, insurance companies, investing company or holding companies, PB valuations works like a charm!
You are asking why! I know. Let me elaborate!
In companies such as banks, all or most of their assets are very liquid and light. Light assets means assets like real estates, bonds, debts, and gold which can be easily converted to cash, and have a steady cash value. PB valuation works really well at evaluating the company's intrinsic value because it's asset value are so close to it's book value.
So the lesson is... PB evaluation can only be used on financial institutions or companies with highly liquid assets.
Warren Buffet made the mistake of using PB valuation on Berkshire Hathaway, and he call it one of the greatest mistakes he made. However, I see it differently... He made that mistake, so we don't have to...
For your reference only...