Thread by @MnkeDaniel

All you need to know about Value Investing in one Thread 🧵

If I do my job, you'll know how investing works at the end of this thread.

Let's start!

1. The Assumption

Value investing is based on one assumption.

Markets are Inefficient.

What are inefficient markets, you may ask?

In an inefficient market, asset prices do not accurately reflect their true value.

The market makes mistakes.

Mispricings occur and offer opportunities.

Opportunities to benefit from that mispricing.

If you're able to find mispriced assets, you can make money of them.

Here's how that works:

Company X sells for $5 a share.
You conclude it should sell for $10 a share.

That's a 50% discount, thus 100% upside.

Now, two things are important here.

First, how do figure out the companys true worth.

And, how is the company reaching that true value?

Let's start with the latter.

Remember our general assumption?

That markets are inefficient?

Well, we have to change that up a little.

Here's how:

Markets are inefficient in the short term but efficient in the long term.

So what does this mean, and why is it important.

It means that markets make mistakes in the short term but figure them out and correct them eventually.

That's important because prices could be wrong forever if that's not the case.

If Company X is worth $10 a share, but the market never realizes that, you don't make any money.

So what do we have so far:

• Markets are inefficient in the short term, but efficient in the long run.

• Buying an asset for less than its worth makes you money

2. Figuring out what a business is worth

In Value investing, we talk about intrinsic value.

That's our measure to find out an asset's true value.

Let's dig deeper:

Intrinsic Value is...

1. an estimate, not a precise number

2. dynamic; changes in the business cause changes in Value

3. our measure to identify bargains

The higher the discrepancy between intrinsic value and the current price, the higher your upside.

Back to our Company X, which is selling for $5 a share.

Intrinsic Value per share:

$2.50 -> 50% downside
$5 -> 0% upside / 0% downside
$10 -> 100% upside
$15 -> 200% upside
...

What did you notice?

Intrinsic Value is not only telling you how much upside there is before it reaches fair value.

You can also figure out the downside.

That's where the next principle comes to play.

3. Focus on the Downside

Assessing how much upside an investment has is hard.

You don't know how euphoric the sentiment might get.

(the price could go much higher than fair value)

Figuring out the downside is much easier, intrinsic value tells you.

If the discrepancy of intrinsic value and the current price is negative, that's the downside you have to face.

Example:

Company X sells for $5 a share
You estimate an intrinsic value of 2.50$ per share.

Consequence:

Possible downside of 50%.

Those are bets you don't want to take.

Value investors, therefore, use a margin of safety.

Example for Margin of Safety:

Company X sells for $5 a share.
Intrinsic value: $7.50 a share

Margin of Safety: 50% or $2.50

The higher the Margin of Safety, the smaller your downside risk.

Choosing investments based on the Margin of Safety instead of possible upside is widespread in the value community.

Howard Marks Philosophy is:

“If you avoid the losers, the winners take care of themselves.”

This principle didn't become so famous because people simply dislike losing.

They do, but if you would make more money by focusing on the upside, that's what people would do.

But that’s not the case. Principle 4 explains why.

4. Compound Interest

The magic of investing.

Have you seen the chart of Warren Buffett's wealth?

It's astonishing. If not, here it is.

https://twitter.com/DividendGrowth/status/1432297046308962305

This curve, more or less, is exponential.

Buffett understands compounding better than anyone.

And what is the crucial rule for compounding?

“Never lose Money.” - Warren Buffett

How do we achieve that?

Principal 3, Focus on the Downside!

I know, one big question is still open... Intrinsic Value.

How do you get an estimate of intrinsic value?

That question deserves a thread of its own.

Yet, I promised you that you know everything you need to know after this thread.

So I cannot let you go without anything on “calculating” Intrinsic Value.

In general, it's simple. Do your research.

It's more research and information than actual calculating and formulas.

Research these topics:

• Financials
(Stable Income, Cash Flows, Balance Sheet)

• Growth
(Growth Rates in the past, outlook for the future, planned projects and investments)

• Management
(Track record, Skin in the Game/Do they own Stock?, Future Plans, Reputation)

As I said, intrinsic value is an estimate.

You don't end up with a number but with an idea, a range.

Apply a margin of safety that you're comfortable with ( 20%, 40%, or more) and buy bargains.

That's it!

I hope you have a better understanding of investing now.

Any questions? Write them in the comments below 👇🏼

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