Value investing rests on three key characteristics of financial markets:
1. The prices of financial securities are subject to significant and capricious movements.
2. Despite these gyrations in the market prices of financial assets, many of these assets do have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor.
3. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run.
Think of this formula as the master recipe of Graham and Dodd value investing:
- Selecting securities for valuation;
- Estimating their fundamental values;
- Calculating the appropriate margin of safety required for each security;
- Deciding how much of each security to buy, which encompasses the construction of a portfolio and includes a choice about the amount of diversification the investors desires;
- Deciding when to sell securities.
These are not trivial decisions. To search for securities selling below their intrinsic value is one thing, to find them quite another.