#30: Respect the efficiency of markets.
Value investing is seemingly more popular than ever. Books on value investing continue to multiply. Several universities offer programs based on the principles of value investing, and a number of MBA programs send their students on pilgrimages to Omaha to meet with Warren Buffett. These schools produce many trained specialists who find work in various value-oriented hedge funds and money management firms. The web is full of various sites and blogs – like this one – that follow a value investing philosophy.
It is impossible to assess the collective fruit of all these efforts. It is, unfortunately, very possible to be well versed in value-investing methodologies and still fail to produce above-average results.
One thing that can lead to sub-optimal results is under appreciating how efficient the market is most of the time. Wall Street is full of a lot of smart people who dedicate tremendous energy to following the market. The Internet has only made it easier to stay on top of the latest news and information. It is wise to recognize this reality and remain very humble about being able to gain an edge on the basis of better research alone.
In spite of these highly transparent markets and trained professionals, the short comings of human nature are still occasionally on full display, in the form of multitudinous frailties, overreactions and misjudgments. You absolutely want to look for these periodic occasions when the person on the other side of the trade is acting in a way that is irrational.
This is precisely why the Mr. Market parable is so central to value investing. As Bruce Greenwald put it in an interview withThe Motley Fool, “Graham saw was that the best indicator of irrationality – sort of a systematic, statistical indicator of irrationality on the other side – is when things get oversold.”
Exploiting this is not so much about having an information edge over the other guy – although you must thoroughly do your homework – as much as it is having an edge in temperament. That is why your search strategy should focus on spotting situations where securities are clearly oversold and sellers are acting irrationally.
Most of the time these are unavailable, but, when they are, you must pounce. These are where the big money is made and where the true, professional value investors, who consistently beat the market, operate.
#31: Focus on ten years out.At its core, investing is about putting out money now to get more in inflation-adjusted dollars in the future. To be done intelligently, this requires you to be able to predict with meaningful accuracy the future economic development of a business. If you cannot do this, it is impossible to handicap the odds and make a rational calculation of the odds of loss times the amount of the possible loss versus the odds of a payoff times the amount of that payoff (the essence of rational investing).
The right framework – and arguably the most important question – is thinking about where the business will be in ten years. It challenges you – if you are honest with yourself – to decide if you really understand the business. For some reason, this is more of an issue with buying stocks than buying an actual business. A buyer of a private business naturally thinks about where the business will be in ten years – perhaps because he intuitively knows that there will be no greater fools around to buy his stock at a higher price. His fate will be entirely determined by the economic performance of the business. The irony here is that the same applies when buying a stock. It is just that so many have been impacted by the faulty thinking so prevalent on Wall Street, which tends to view stocks as lottery tickets rather than pieces of a business.
Thinking about where a business will be in ten years gives you an edge because so many of your competitors are focused on the short term. If they don’t get the short term right, there will be no long term they reason, so they stick close to the herd where they can find refuge in mediocre relative performance.
Thinking about where a business will be in ten years is a powerful filter that will save you research time because it allows you to quickly eliminate businesses where it is impossible to determine (not necessarily impossible per se, but for you, which is all that matters). Generally speaking, change is the most common reason that makes it impossible to judge where a business will be in ten years: rapid technological changes, no moats with competitors flooding in, decaying business models, and creative destruction are all common contributing factors.
As Buffett is fond to stress, it does not matter if the number of businesses you can predict is small. Fortunes have been made concentrating in one business that is deeply understood. Think Rose Blumkin. Put a premium on certainty, even if it means giving up some potential return. Compounding is the wealth engine, and many have disrupted its magic by overreaching. If you are more or less certain that you have a good understanding of where the business will be in ten years and you wait for a price that allows you to meet your hurdle rate, the odds will favor you beating the market.
#32: Average down when buying – average up when selling.How many times have great value investors affirmed the wisdom – and profitability – of this simple advice: average down when buying and average up when selling. How few – even those who understand its inherent logic – fail to do so on a consistent basis. It takes enormous discipline to not take a valuation cue from price action. Yet this is precisely what the great ones do not do – they take their cue from a dispassionate, margin-of-safety-infused estimate of intrinsic value. Without this practice, the Mr. Market parable is of little use, reduced to a quaint anecdote of Buffett’s mentor, Ben Graham.
Gurufocus has a nice feature where you can see both graphically and in tabular form the historic equity purchases of prominent value investors. How often have I observed that the best, focused value investors frequently buy more – sometimes much more – when a newly established position craters down in price. Conversely, I have frequently seen the same investors average up by selling a portion of their shares if Mr. Market makes a particularly tantalizing offer. This can result in a staggering IRR on the sold portion and greatly reduce the risk of capital loss on the remaining shares as they are held for greater gains.
In his recently published 2012 letter to Fairfax Financial shareholders, Prem Watsa – a preeminent practitioner of value investing who has grown book value by over 23% per year over 25 years and generated a 14% annual return on common stock purchases over the past 15 years – recounts how Fairfax Financial generated a realized gain of $341 million from International Coal (ICO) using precisely this technique. (Prem lays it all out in tabular form). After initiating a position at $4.58 per share, they averaged down, bringing their average cost down to $3.37 per share. They subsequently sold half their position for a gain of 115% at $7.26 per share. The remaining shares were sold only five months later when there was a takeover offer for the company at double that price. (Fairfax sold at $14.60 per share.)
This was done without buying at the low or having any special ability to see into the future. All that was required was the right intellectual framework and emotional discipline. Watsa relates how he has been using exactly the same investing technique for the past 35 years.
Incorporate the same approach into your investing process and you will greatly increase your odds of beating the market.
