What exactly is value investing, is it for you and why does Charlie Munger call it "twaddle"?

I got a note from a friend today about value investing and he equated it to buying a broadly diversified set of stocks via a low cost index fund. To me, this approach is passive investing and BY FAR the  best approach for most investors, me included. So why the heck am I picking stocks? Well, to be clear, I use a low cost passive approach through Vanguard for over half of my meager holdings. But I love the game of picking stocks. In fact, I think I'm addicted to it because over the course of about 20 years in the market, my own picks have been trounced by my passive funds and yet I still pick stocks. I just think it's fun and I love reading about interesting companies and testing my hypotheses about them using real money. Sure, I hate seeing my dough go up in flames, but when I get something right, well, I just forget all the times I got shellacked.

But back to value investing.

What is it exactly? It's simply buying an undervalued stock and waiting for the Mr. Market to realize his idiocy and price the stock accurately. But what exactly is an undervalued stock? I go to the Oracle of Omaha, who defines undervalued as a business priced for less than its intrinsic value. And therein lies the rub. How on earth do you figure out the intrinsic value of a business? If you're a person who enjoys reading financial statements for hours every day, has a brain that can do differential equations pretty much instantly, and an elephantine memory -- all qualities of Buffett -- you can probably do it. In Buffett's early days, he was able to find companies that were wildly undervalued for the simple reason that while information was hard to come by (there was no internet!), he was willing to do the required sleuthing through reams of reports and piles of newspapers AND had the ability to make sense of it all AND retain information so that when he found anomalies he could recall them instantly and correlate them with other data in his brain (truly, he is not a computer user or note taker so far as I know, he just remembers EVERYTHING) and make buying decisions. Can you do that? I certainly can't and I doubt most other mortals can either.

But wait, there's more.

Another core aspect of value investing is what Buffett calls a "margin of safety", meaning a stock must be undervalued by quite a bit so that even if an investor is a bit off on his intrinsic value estimation he still comes out ahead.

And more...

Charlie Munger, Buffett's partner at Berkshire, claims, rightly so in my opinion, that an investor must not only know his circle of competence but also not step outside of it. For this reason, Buffett and Munger stay away from businesses they don't understand. I read a great anecdote about how they start their evaluation process. They have two piles: one is stocks to consider and investigate further, the other is stocks that are "too hard". And this sorting is ruthless. If they feel at all murky on why a business might be a good investment or not, they put it in the "too hard" pile, meaning they pass on just about everything (which explains why Berkshire has so much cash).

Wait, two more things about value investing (at least the way I understand it, which is based on what I've read about Buffett and Munger)...

First, and this is straightforward, a value investor holds stocks for a long time, at least 3-5 years, but Buffett prefers forever.

Second, value investing, as practiced by Buffett and Munger, is not at all passive or even what I would call conservative. These guys are as active as investors get, actually taking full ownership of many of their investments and gently guiding the management of the businesses they own. Further, when they bet, they bet big. Munger talks about this a lot. Because he and Buffett stay in their circle of competence and have a system (determine intrinsic value and margin of safety) when they bet, they bet big, and not just in terms of total dollars, but also in terms of the total percentage of their holdings. Here's Munger: ...the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.

I can't help myself, here's one more tidbit about value investing, which I agree with:

The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But, to me, all intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock.
— Charlie Munger