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Author: kcchongnz | Publish date: Sat, 15 Sep 2018, 03:30 PM

I like to borrow the terms originally proposed by the psychologists Keith Stanovich and Richard West to refer to the two systems in the mind as mentioned by Noble Prize Winner in Economics, Daniel Kahneman; System 1 and System 2.

System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.

System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operation of system 2 are often associated with the subjective experience of agency, choice and concentration.

In my last article, “What is value investing?” in the link below,


I took the effort to explain what value investing is. One statement I made was as below,

“So, value investing is intelligent investing. Value investing is about looking for a mispriced gamble, getting more than you are paying for. It is not just about buying cheap stocks. You must know about the business and hence the value the business.”

The above obviously requires the “System 2” in the mind, and not the “System 1” kind of response, which comes out in the spur of the moment, is superficial, uninformed and often incorrect conclusion as below,

[Posted by qqq3 > Sep 14, 2018 02:15 AM

value investor? go and buy up all the dead shares la....a Lot of the dead shares have discounts of up to 70% from the "revaluations"/valuations of assets.]

But then, what else can we expect from him?

“Value Investing; you either get it, or you don’t”

With that, let us just move on.

Origin of value investing

Value investing was first made known by Benjamin Graham as a set of tenets when he wrote Security Analysis in 1934. Fundamentally, value investing involves buying stocks that are out-of-favour in the market due to investor irrationality. This irrationality, in the extreme, can often push a stock’s price well below its true value. A shrewd value investor seeks to determine the true value of such stocks, thus taking advantage of this type of investor irrationality.

There are several key principles and concepts that underpin the value investing mind-set and are central to the philosophy espoused by Graham. Two principles in particular stand out: firstly, the value investor always takes a business owner’s perspective when analysing a company. Secondly, the value investor always counts on the irrationality of the markets in the short term (Mr. Market). Once these two principles are established during the evaluation of an out-of-favour stock for purchase, the value investor must follow the additional principles of determining intrinsic value and a margin of safety.

In short, the key principles are:

1. Price is not value

2. Mr. Market is a crazy guy

3. Every stock has an intrinsic value

4. Only buy with a margin of safety

5. Diversification is the only free lunch

Key Principle 1: Price is not value

The first key lesson for the would-be Value Investor is that the worth of a business is independent of the market price. A stock quote from day to day is only how much just the few shareholders who bother to trade that day decide their investment is worth. It is categorically not the worth of the entire company.

This is the reason share prices so often spike when being bid for by an acquirer, who generally has to pay something closer to fair value. Investors should understand that the share price is like the tip of an iceberg – you can see it, but you’ve no idea how big or small the iceberg is below the surface unless you put on your dive suit.

As Ben Graham observed: “price is what you pay, value is what you get”, meaning that big swings in the market don’t necessarily mean big swings in value. When you buy a stock, you are buying ownership of a business with real assets, the brand, the people behind it. Should that really change just because the market is moody or plagued by worries about liquidity? As long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.

Key Principle 2: Mr. Market is a crazy guy

In Graham’s “The Intelligent Investor”, a book which is required reading for all new analysts at top investment firms, the author conjured his now infamous parable of Mr. Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr. Market. He’s a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis. But Mr. Market is something of a manic depressive whose quotes often bear no relation to the state of the underlying business – swinging from the wild enthusiasm of offering high prices to the pitiful gloom of valuing the company for a dime. As he explains, sometimes you may be happy sell out to him when he quotes you a crazily high price or happy to buy from him when his price is foolishly low. But the rest of the time, you will be wiser to form your own ideas about the value of your holdings, based on updates from the company about its operations and financial position.

Key Principle 3: Every stock has an intrinsic value

The critical knowledge an investor needs to take advantage of Mr. Market’s behavior and inefficient prices is an understanding of the true value of a business. The true value of a business is known as its ‘intrinsic’ value and is difficult, though not impossible, to ascertain.

Most investors preoccupy themselves with measures of ‘relative’ value which compare a valuation ratio for the company (perhaps the price-to- earnings, price-to-book or price-to-sales ratio) with its industry peer group or the market as a whole. These metrics are useful as quick and dirty checks, but inevitably though, something that appears to be relatively cheap on that basis can still be overvalued in an absolute sense, and that’s bad news for the Value Investor who prefers to tie his sense of value to a mast in stormy waters.

Intrinsic valuation looks to measure a company on its economics, assets and earnings independently of other factors. But be warned, establishing an intrinsic valuation is not straightforward and there are multiple, contradictory ways of calculating it.

Key Principle 4: Only buy with a margin of safety