Warren Buffet has written a great deal on value investing, a technique to investing that he has used to consistently outperform the S&P 500 over the past 20 years.  A short summary of his work can be found here  .  Value investing is not a new concept, it was most famously written about by Ben Graham in his investing classic, the Intelligent Investor, and it consists of a process of buying stock in solid companies that can be bought at a discount to their intrinsic value.  A solid company is one that has paid consistent dividends, has had great returns on capital, and has produced significant amounts of cash profit as a percentage of revenue. While this may not sound revolutionary, its implications are outstanding.  Firstly, value investing does not concern itself at all with what other investors think about a stock, it only instructs the investor to buy based upon a detailed assessment of the company.  Some of Buffet’s best performing stocks, like American Express, were sluggish to rise in price because it took a while for other investors to realize that a mainstream, often overlooked company can be a great company to own.

Another way of viewing value investing, and stock picking in general, is through an information cascade.  A simple model for the value of a stock might be what an investor thinks it is worth, through financial analysis, plus its popularity.  News shows, newspapers, and news reporters make their living telling investors which stocks are “hot” or are popular at a particular time.  Most investors will make no money over time by picking “hot” stocks.  The biggest flaw in investing based on popularity, or what other people are doing, is that it is impossible to predict the popularity of a stock in the future.  Popularity is not quantifiable, it is speculative.  Investing by following trends has been proven to be at the very least market performing, and as lethal as being caught in a bubble, like the 1990’s tech bubble.  However, value investing disregards what other investors think of a particular stock, instead postulating that the true value of a stock will be revealed in its price over time.  One chapter in Graham’s book, the Intelligent Investor, speaks about the need to control the natural urge to invest in what is popular.  For example, a profitable company, like Caterpillar, which might not have been as popular to invest in during the tech boom, turned out to far surpass most tech stocks in the following years because it was a solid company, making solid earnings, and its intrinsic value was realized in its price over the following few years.