When we left off yesterday, I said we were going to present you some important information that will help illustrate a very precious set of rules that all value investors need to follow.
You have to be very disciplined in your investing, and constantly remind yourself of the main principles that will help you master the craft of being a value investor.
Let’s get into the information without further delay…
Be greedy when others are fearful
In a Berkshire Hathaway shareholder letter published by Warren Buffett in 1994, he said the following:
“we will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen,” said Buffett.
“Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the flow of the faddist, but the friend of the fundamentalist.”
The final sentence in the quote is of major importance since human beings typically react to their emotions instead of viewing things in analytical terms.
As an example, “I want to wait for this stock to trade lower” could very well mean “I am afraid to pull the trigger.” The “equity risk premium has increased” could also mean “people are becoming more fearful.”
“Expected return per unit of volatility of equities has increased” could also be looked upon as “people are more bearish about stocks.”
If you choose to invest based on analytical tools, such as portfolio weighing and discount rates, it’s more like the tail is wagging the dog, unless of course you use the signals as contrarian indicators.
Be fearful when others are greedy
It’s often hard to maintain price discipline when you see record low interest rates all around the world.
If we can look at a Texas hold ’em analogy, any investment strategy where you are playing your hand more loosely, and you’re willing to pay higher for businesses, will most likely generate higher short-term marked to market returns in today’s environment. This is because continuous money printing means that blinds will continue to go higher for all investors, so that the investors have to put in more.
Even so, value investors that hang onto their price discipline will most likely come out better on the other side for the long term. Because let’s face it, the looser investment strategies will most likely have a component of catastrophe put option selling. The people who pay more for a business have less margin of safety – which is the cushion to protect against potential losses when unforeseen downside risks, bad luck and analytical errors rear their ugly head.
If you do not have a margin of safety, an investor is at much greater risk to sustain permanent capital loss, and negative scenarios could potentially occur. But in the meantime, the investor will collect a put option premium, which could very well show as strong interim marked to market returns.
Volatility is not a great way to measure risk
The amount of risk is often underappreciated in regards to catastrophe put option selling. Since long-term investors do not often take money off the table, the end goal is the most important part of any major investment strategy. Cat-insurance selling will not likely be well captured by conventional market price-based measures of return per-unit risk, and this includes the Sharpe ratio.
In more general terms, it seems counterproductive that risk is basically measured by using observed market price movements. Even though the best time to sell any catastrophe insurance is right after the catastrophic event, the best time to actually underwrite a downside scenario for a business is when the scenarios occurrences already figured into and part of the stock price. You have to worry the most about any risk that isn’t already observed.
You pay for price; you get value
is a very simple fact underlying the value investors approach: the current quoted price of an actual security only matters when you are trying to buy it when you are trying to sell it.
Mister Market must offer a very comfortable price that we really like if we are going to buy it, and he also has to put up a great price on any security that we are about to sell. At any other time while we own shares, we just sit patiently and wait.
If you want to stack the deck in your favor even further, we don’t even have to have any opinion about most of the stocks and securities they offered on the market every day. You just go to the stock market with your own shopping list of stocks that you’d like to buy at a particular price, or you can go to the bargain bin and see if you could find a great deal that way.
Do not lose money
When you look at value investing, you see that it is logically the best way to go, although it is difficult from a psychological standpoint.
If you knew for a fact that Company A’s stock is currently worth $100, then you wouldn’t have any problem buying their shares for $60, and you’d be lucky to grab even more their shares if they were selling for $30.
But in reality there are a lot of barriers to this knowledge. There is a lot of uncertainty when it comes in the future, there are limits to what information is available to the public, their ambiguities in complex systems which limit the usefulness of this information, and there are limits to an investors competence and their ability to analyze.
The one thing we know for certain is that knowledge is slippery, and often humbling. The more we learn about a company through our research, the less we realize we actually know about them.
Yet we have to steadfastly hold to our belief that each company possesses an intrinsic value, and we can figure out a way to estimate that value.
The best way to lose money is to throw good money at bad money. If you made that calculations with intrinsic value, and your numbers are off, then sometimes you just have to accept defeat and move on. Don’t hold out on a loser even though you know it’s never going to reach the price you expect it to hit.