Within the investing space, there are various forms of investing or trading. Some investors are very short-term an in fact traders. These can be traders who focus on charts and do technical analysis. There are some traders that are day-traders that only trade stocks during a single day closing their positions before the end of trading each day. These investors are in essence called speculators. On the other side of the spectrum, you have long-term investors such as Warren Buffet, Benjamin Grantham or Seth Klarman that are considered “Value Investors”. Value Investors focus on more on the intrinsic value of the company the most important thing. They focus less on short-term price movements or other factors that are not related to the company. We have previously covered one facet of value investing, with the run-through of the fundamental approach of DCF valuation.
As most professional investors often have different buckets of how they invest. For example have 45% of their funds focused on value-investing, another 45% on more trading oriented investing and 10% on more speculative long-shots. We will go through the main lessons we have learned over the years using a value investing approach to investing capital.
Value investing per-se is not an advanced form of investing. One does not need to know advanced mathematics or super deep knowledge of various facets of finance. Most value investors are not super advanced analytical savants who create complex computer models to find investing opportunities. Value investors’ most important probably most difficult trait is to have discipline. When looking at an investment on a long-term horizon, one needs patience, not rushing to judgements or only investing when the right opportunity comes along. This might seem straightforward and easy advice, but being able to sit on the sidelines waiting for the right opportunity, when a potential investment hits right levels is difficult. Inherently investors want to “do something” and put money to work.
By definition, value investors are almost all contrarian, differentiating from the crowd. The way one as investors find the best bargains is the look at parts of markets, sectors that are completely out of favour with the general investing crowd. A value investor often challenges the conventional wisdom on the investing market and goes against the prevailing “hot themes”. Again this means that potentially over long periods of times as a value investor one underperforms the general market. A value investor knows that as the share price of a company rises, it becomes more risky not less. For example value, investors had an abysmal relative performance during the IT bubble of the early 2000s. Eventually, they did receive vindication as the IT bubble crashed and value-stocks that were so much out of favour at that time, and share prices declined massively outperformed general IT sector.
As a value investor is it important not be beholden to the Market and its movements. In other words to take a step back an fully trusting one’s own analysis and not blindly following the market let say in situations where markets drop substantially. In the end, the market is just the collective actions of millions buyers and sellers, who themselves are not always motivated by investment fundamentals. Learning this lesson is fairly difficult. Naturally, if an investment one has dropped massively, one just wants to limit one’s losses and sell right away. Instead of believing and trusting in one’s own analysis and knowing these massive price movements are short-term in their nature.
One of the most important lessons’ one learns as an investor is not to conflate share price of a company with the business relative. Just because the share price of a stock rallies does not mean that the underlying business is doing great, or vice-versa. A share price increase might not fully justify the same increase in the underlying value, or for that matter the opposite of share price decline with the corresponding reduction of value. Even though at least on short-term perspective this might be true, it often leads to over-reaction over a longer term. Of course, in general, especially in trending markets, buying beget buying and selling begets selling, as a value investor one most realize these movements might not reflect the underlying value of the asset.
On the same principle, as a value investor one must look at the share price in relation to the value, and not just the share price when making decisions. In other words, large share-price movements that lead to deviations from the underlying value creates massive investment opportunities for a value investor, whilst just blindly following the share price of a company as guidance for making an investment (something short-term traders and speculators do) is a recipe for disaster for value investors. A key pillar of value investing is to do one homework and due-diligence on the intrinsic value and being prepared when the share-price deviates from this value and make an investment.
Being a value investor (for that matter any other type of investor) it is important not letting one’s emotions take over. The best to achieve this is to have a sound and rock-solid intellectual framework and investment process. Following one’s process and staying true and disciplined to this process minimizes the likelihood that any potential emotion affects one’s investment decisions.
These are the most fundamental lessons that come value investing. They are very straight-forward and rational, but as any long-term and professional investor knows, it is easy to know of the rules and lessons and much more difficult to consistently follow these rules and frameworks. What I have learned over the years as the more seasoned investor I have become, when religiously follow these rules and lessons I deliver consistently good results. Often, when I have had a good investing run, I used to lose my discipline and get a bit reckless not following my own rules, resulting not too far after underperformance.
A true value investor mind-state is not about trading in and out of an investment or position. This might be true for other types of investors, but for a value-investors, following process and having discipline means buying stocks when they hit the fundamental analysis levels and letting the stock work for you over a long period of time instead of trading out after quick return. In essence, the greatest benefit is to focus on the compounded return which can result in massive gains over a longer period of time. This lesson seems obvious, but for a true value investor, this is one of the main commandments. All the hard and extensive work is done to have an investment over a longer period of time and not trade out quickly.
Warren Buffet has noted that one if comparative advantages is that he has a longer time horizon in his investments than most other investors. That allows him to see clearly true value and the process. Within the institutional investor, environment focus has shifted to more and more short-term performance. This has led to investors who previously traded less frequently are now trading extensively and are more focused on beating their “benchmark” than actually generating good returns. As most of these portfolio managers get compensated not on how they perform (returns) but on how much assets under management, conflict of interest arise. Managers are more focused on expanding the amount of assets they have and less on generating returns. As a value investor, this creates a comparative advantage. If your competitors are less focused on long-term returns and more asset gathering, this gives anyone that targets all their efforts on the long-term, returns will be there.
Price matters. In other words, even though as a value investor one does not trade for the sake of trading, it is important to make an investment when prices hit the fundamental value based on your analysis. The true definition of value investing is to buy a company at a significant discount to value. The larger the discount, the bigger the value and the less the risk one takes.
With that said, there will always be price fluctuations in all types of stocks. As a value investor one needs to be able to distinguish between operational risk and price fluctuations. Often as an investor one thinks just because the share price of a stock goes down the risk of the investment increases when a fair amount of time the opposite is true. As a value investor, the focus lies into assessing and analyzing to distinguish if the price movement is just temporary volatility or actual changes to business fundamentals.
Even if there is uncertainty about short-term price movements of a stock, if you can buy a stock at steep enough of a discount, the margin of safety is enough. In the long run, these price fluctuations don’t matter, the value will ultimately be reflected in the price of the stock. Paradoxically, short-term price volatility that plenty of investors see as a risk, is a blessing for value investors as it gives them an opportunity to snap up stocks they like.
One could say this should be the most important lesson of any type of investing. Warren Buffet likes to say the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” As a value investor, the application of this rule does not mean that investors should not incur any losses at all, but more than one’s portfolio or investments within it should lose any principal over several years indicate that the investment thesis on one or several of one’s investments are incorrect. Sometimes value investors talk about they have extremely long time horizon (see the previous lesson) but this does not mean one should get sloppy and accept continues decline and underperformance of any investment.
We have looked further into important lessons of being a value investor. The overarching theme from these lessons has been having a long time horizon. Focus on the compounding effect of long-term returns instead of short-term trading. Remembering that using price fluctuations and massive declines an opportunity to buy stocks at a discount instead of getting too caught up on the short-term fluctuations. Following the main lessons from part one of having discipline and focus on process, by buying when the price reaches the value territory instead of just taking short-term market pricing as given. With all this said, the most important rule of all investing is not to lose money. For a value investor this a long-term concept of just because the price of something goes does, there is automatically more value. As an investor, regardless of what type, one needs to follow the rule of, if fundamentals in ones thesis change negatively one needs to take that into consideration and not blindly staring one’s original thesis. This is another way of stating the famous economist Keyes quote of “when facts change I change my mind”.
We discussed in earlier articles that the most important lesson is not to lose money. If one experiences big losses in a situation, it will be much more difficult to recover and have compounding returns for the whole portfolio. A big loss can basically wipe out all the hard work on disciplined stable returns one has build-up with other investments. As an investor, the likelihood of doing well is much higher when with stable and consistent returns and limited downside than situations with massive gains but with substantial risk for one’s investment. For example an investor that has annual returns of 16%/year over 10 years earns more than an investor that gains 20%/year for 9 years and then loses 15% on the tenth year. Value investing is like the old fable of the Hare and the Tortoise, “slow and steady wins the race.”
All good value investors know that they cannot get every decision right. Even though we strongly talk about avoiding to lose money as the most important lesson, there will be situations where one is wrong, or something unexpected happens and losses hit. The best way to avoid or minimize these type of situations is to plan ahead both on a portfolio level and single name investor basis. There are various forms one can do this. For example, by buying out of the money provides options in case something happens. One must be willing to forgo short-term returns and have “insurance” against the unexpected happening. Often in the financial markets, there is talk about “4, 5, 6…etc sigma-events”. This means that something based on models would only happen once every thousand years. Interestingly enough, it appears that these type of “model-events” tend to happen fairly often. The 2008 financial crisis being the prime example of this. As an investor, one thing is certain, there are going to be unexpected negative surprises happening all the time. The question lies in how one prepares for them.
Another way of preparing for the worst – is buying assets that are trading at a substantial discount to their underlying value. In other words, buying a bargain. By buying an asset that trades at a significant discount is an indirect way of preparing for the worst. There is a much smaller likelihood that a surprise negative event will cause massive losses on something that has already been hit hard than a stock that trades close to highs. Also, the margin of safety is an insurance against human error, bad-luck, massive macro events having a negative impact. Value investors actively include the margin of safety in their investing process. Not only are we humans imperfect and produce mistakes, but the world is an uncertain place and negative surprises happen all the time. Insure yourself through protection and buying assets with a large margin of safety.
Often we hear investors both professional and non-professional start the conversation about their investing in stating how much they want to make a year. For example, stating you want to achieve 20% yearly returns without addressing how you will achieve it. Unfortunately, returns are not a function of how hard you work. Within investing, you won’t make more money by “thinking more.” For an investor, all he/she can do is to focus on having a disciplined process and over time returns will come. Another way of saying this is tying it to our margin of safety and preparing for the worst lesson. As an investor, you cannot plan for how much return you wish to return. But you can target how much risk you can take as part of your investment process.
As an investor, especially as a value investor, one does not have to do anything. Often just doing nothing and sitting and observing is the best action possible. An important lesson is sitting back and studying various companies through different cycles. Do your analysis and invest at the right time. If you do not fully understand the business or the underlying risks with it, just because it looks interesting there is no need to invest. Have patience and make sure you understand the business and invest at the right time. There is no need as a value investor to be fully invested at all times. Most institutional investors such as mutual funds feel forced to be invested at all times, as they are not getting paid to just sit on cash. As a value investor you have none of these problems. As a retail investor, you have no obligations to be fully invested at all times and swing at every pitch. Instead sit back and study and swing when the moment is opportune. When one does not feel the pressure to invest the best opportunities arise. Avoiding premature investment in a business can be detrimental as well.
Often in bull markets, value investors don’t really see any good bargains as stocks trade at their highs. In those situations whilst most market participants talk loudly, value investors just sit and observe. On the flip-side, during massive downturns and market panicky markets, plenty of opportunities show-up. As other investors are throwing out the baby with the bathwater, these are the period’s value investors do most of their investing. The number of undervalued stocks and the level of their undervaluation increases in a bear market, whilst there is an inverse relation of this in a bull market.
Again we come back to the notion of discipline and process. If a value investor has good discipline and follows a well-thought-out process, bad pitches in expensive markets can be avoided. And one is prepared for snapping up bargains in cheap markets.
In this part, the main lesson we wanted to convey is having patience and waiting for the right moments to invest. Furthermore, we broached the idea of preparing for negative surprises in whatever shape or form. We as investors are not perfect and there will always be negative surprises. One can either buy insurance to avoid these situations or buy with a greater margin of safety to provide a good cushion when things turn.
One of the most important lessons one learns as a practitioner in the markets is that just when one thinks one has learned and understood a situation, the markets and stocks behave completely differently than expected based on the known data. When it comes to value investing, an investor does deep and fundamental work. One conducts research and analysis various drivers of the business. One critical mistake one can make is assuming one has all the relevant facts about certain investments. For example, there might be variables and questions that are unknown to one as a value investor. All the right questions could not have been asked. This is another way of saying there are “known unknowns but, one does not know the unknown unknowns”. In addition, unlike science, one can know all the facts and data perfectly as an investor and still get the investment incorrectly. Almost all investments are dependent on outcomes that cannot be accurately foreseen. Investment reality is not something stagnant. Business values don’t always stay constant. All of this means that even though one has done the deep analysis, one cannot be certain of a specific value. This results in that as an investor, one cannot ever be confident buying a stock at a discount, as not only are external factors partially driving the value but also that one can never be certain one knows the facts.
Often one sets an exact value to an investment. As a value investor one have the inclination to set a precise value on something after all the deep work. That is contrary to how the world is built up. One cannot set a precise business value in an imprecise world. All the variables one look at as a value investor, such as book value, earnings, cash-flows are all in end just best guesses. Furthermore, all variables constantly change. Macro, micro and market-related factors give a further level of uncertainty. One needs to continuously re-assess the assumptions and variables one uses to make a valuation. One needs to be cognizant of the difference of trying to make precise assumptions and forecasts with making accurate ones. We can easily have a precise fundamental valuation as we described in our DCF analysis. That does not mean the value is accurate. The output does not mean anything if one does pay full attention to the inputs. “Garbage in, Garbage out” is an easier way of describing it.
In their Value Investing Bible, Security Analysis, Graham and Dodd address this notion a range. They write:
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate – e.g., to protect a bond or to justify a stock purchase or else that the value is considerably higher or considerably lower than the market price. For such purposes, an indefinite and approximate measure of the intrinsic value may be sufficient.”
Sometimes, the simple analysis will give a more accurate assessment of a company’s value than deep in-depth analysis with plenty of uncertainty about the inputs.
As we have pointed out several times, as valuation is an imprecise art, the future is unpredictable and we as humans all make mistakes margin of safety is needed when we invest. Especially as value investors. The follow-up question is how much margin of safety do we need to take into account to feel secure in our investments? The answer differs from one investor to the next. It all boils down to how much are you as an investor willing and can afford to lose. This in itself is not a good argument, as no one wants to lose anything, but one needs to take the variable in consideration when assessing how much margin of safety to have in an investment so make sure the likelihood of having losses are smaller.
There are several different ways one can “increase” the margin of safety in the investments one make. This includes when buying something “at a discount”, making sure the majority the value is based on tangible assets over intangibles (for example Goodwill). Not being married to a position/investments and being open to replacing it if an even better offer comes along. Importantly also, selling an investment when the market price reflects the underlying business value. In other words not getting too greedy. These are all indirect ways of building margin of safety on a continuous basis. This means that one does not forget why one made the investment in the first place and selling the stock when that underlying reason no longer applies. Furthermore, this applies to potential investments as well. One should not only pay attention to whether a stock is trading at a discount to fundamental value but more importantly why is it undervalued.
Finally, try to find investments where you can see a clear path to closing the discount. Often for a value investor, the go-to answer is, the stock will stop trading at discount with time as other investors will see the deep discount as well. This might be all fine, but to get to this “value” for one’s margin of safety, look for investments with catalysts that could help either directly or indirectly closing the discount.
All of the above is always easier to accomplish by having a preference in investing in companies with good management that understand the issues and have a big part of their own wealth invested in the business.
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