Written by Jae Jun

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Can you believe it’s already been over 5 years since the great recession?

Seems like yesterday.

I can still feel that tinge of excitement from when I was picking up dirt cheap stocks left and right.

The obvious advantage in hindsight was that you could literally close your eyes, buy anything and it would go up with the market.

Fast forward to today.

A lot of that mentality is still in the markets. We’ve forgotten what it feels like to have 2% drops. Instead, gut feelings and hope is making up a large part of the process when picking stocks.

And with the low interest rate environment, the consensus is that you need to take on higher risk for higher returns.

Herein lies the problem. The fear of missing out.

Stock markets around the world have been trading with very low volatility recently, with hardly a meaningful correction since mid-2011. This suggests that investors are too complacent about the market and more concerned with missing out on returns than with the risk. – source

It goes totally against what Monish Pabrai and Seth Klarman teach.

Both gurus demand low risk, high return stocks.

No such thing?

Well, tell that to Klarman and his 60% end of Q2 returns (editor’s note: Klarman is not up anywhere near 60%, that stat is ONLY assets which are required to be reported on form 13F, which represents only about 13% of Baupost’s AUM)

In fact, the reason why Klarman has always been able to annihilate the market is because of his willingness to hold cash and buy with a huge margin of safety.

Here’s an excerpt from the Baupost 2004 year end letter.

It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.

The alternative is to remain liquid, defy the steady drumbeat of performance pressures, and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.) This path also involves risk in that there is no certainty whether or when this will occur; indeed, securities prices could rise further from today’s lofty levels, making the decision to hold cash even more painful. Meanwhile, holding out for better returns involves a (potentially lengthy) period of very low (albeit certain) positive returns available from today’s short-term U.S. Treasury instruments.

Sound eerily familiar?

Still afraid that everyone is making money in the market except you?

Well Howard Marks echoes similar thoughts and gives his take on how people view risk.

1. When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stout-hearted contrarians are capable of imaging that improvement is possible.

2. Then the economy shows some signs of life, and corporate earnings begin to move up rather than down.

3. Sooner or later , economic growth takes hold visibly and earnings show surprising gains.

4. This excess of reality over expectations causes security prices to start moving up.

5. Because of those gains – along with the improving economic and coporate news – the average investor realizes that improvement is actually underway. Confidence rises. Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress.

6. Skepticism and caution abate; optimism and aggressiveness take their place.

7. Anyone who’s been sitting out the dance experiences the pain of watching form the sidelines as assets appreciate. The bystanders feel regret and are gradually suckered in.

8. The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities.

9. Risk aversion evaporates and invests behave more aggressively. People begin to have difficulty imagining how losses could ever occur.

Sounds eerily familiar.

Make Objective Decisions with Buy and Sell Rules

To combat some of the common psychological pitfalls of wanting to buy stocks and be “active”, you should have clear buy and sell rules.

A lot like traders.

You can learn a lot from the good ones. The analysis and thought process is different, but the approach and execution is something value investors can benefit from.

Are you still sizing your positions based on how much you like the company story and what your gut tells you, rather than hard rules?

The other day, an article on the Kelly formula was published. That’s just one way to define buying rules.

Or a buy signal can be triggered by something as simple as a stock price meeting your 25% margin of safety price.

Nothing fancy.

Just a simple criteria to make it black and white because an investment ultimately has to be tagged with a yes or a no. The process and analytics may be complicated, but the final decision is binary.

If a stock falls in a gray area, it should be the same as a “pass”, but you find yourself comprising and needing to dig yourself out of a hole later.

Been there, done that.

Here’s another.

If a stock goes up 50% or even 100%, sell a little so that you can lock in some gains. A profit is never realized until the position is sold.

If the stock drops, then you can use the money to purchase more.

Valuation, Valuation, Valuation

When buying real estate, they say it’s all about location, location, location.

But with valuation, the most important factor comes down to valuation.

Klarman is famous for investing in complex situations. But the big reason why Klarman is up 60% in just 6 months is because of his ability to value stocks and continually buy at cheap prices.

Seth Klarman Valuation Matters 1
Valuation – Klarman wins big with IDIX | (Arrows are not exact)

It’s the same for small investors like you and me.

The only way to do well in the market is to value stocks and know what price range to be buying in.

Notice in the chart above that Klarman was buying at various prices over a couple of years.

He knew that anything below $7 or $8 was a bargain compared to the intrinsic value.

I admit, I’ll find it difficult to buy at $8 if I was picking up shares at $4 or $5 earlier. But that’s the importance of knowing your intrinsic value.

Phil Fisher says it best.

Don’t quibble over eighths and quarters. – Phil Fisher

The Right Way to Value Stocks for Outperformance

You know that I use many valuation methods.

Here’s

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