On Value Investing and where it's gone wrong.

Warren Buffet's strategy? There is a better way.

Value investing is a well regarded and highly adopted practice of investing, however, it can be misunderstood and wrongly applied.

This is roughly what you need to do:

1. Buy companies at a price that you consider to be undervalued (after research & analysis).

2. Be able to hold them long enough to extract the upside.

3. But have the fortitude to sell when you your thesis has been proven wrong.

4. And repeat the process in order to compound your gains.

An extra layer of skill which is harder than the above four combined but that has the power to even double your returns is being able to switch from a good investment to a better one. In other words, selling cheap to buy cheaper. 

It’s never easy to sell a company that has given you gains to buy another one. Humans like comfort, and being in the green is comfort – that doesn’t mean it is optimal as well. It isn’t easy to sit and wait for bargains either but for maximum potential, you have to.

Value investing however states that you aim to buy the company that sells the cheapest. That means you have to buy and sell what makes sense.

One of the hardest things for an investor to do is find the “correct” price to buy something. 

Value investors will tell you that the value of an asset today is the present value of its future cash flows till eternity (that present value is called intrinsic value). It goes without saying that you need a certain level of intelligence to even approximately calculate that intrinsic value.

They go on to say that if you buy a company at a discount from that intrinsic value then you will do well – the bigger the discount the better. 

That discount from intrinsic value is called a margin of safety. That is to say safety from the future unfolding differently that you previously expected. If your assessment of intrinsic value is $50/share, don’t buy at $50! Buy at least 20 or 30% lower than that.

But margin of safety is not only for safety - it’s also for profit maximisation. If you buy at $40 and it goes to $50 then you make 25%. But if you buy at $25 and it goes to $50 you make 100%. Compounding those two rates of returns ends up with massively different results.

In other words, all things remaining the same, the cheaper the better!

Now let’s talk a little bit about the doctrine of value investing and how it becomes abused and misunderstood.

The discipline of value investing was started by Benjamin Graham, an accountant by profession made even more famous by his student, Warren Buffet. 

Buffet’s track record has spawned an army of investors looking to emulate his success. The thing is, that’s not as easy. This copy-paste approach has brought on some unintended consequences.

It has produced a crowd of Buffet-Graham wannabe disciples that have spent their lives pounding in the mantras of cheap and value, in a fast changing world of new business models and morphing status quo – focusing on absolute price and conventional valuation techniques when it is unconventionality and idiosyncrasy that you need to have in order to succeed.

For average success, you can obsessively follow the path framed by others. To succeed in a big way, you have to create your own path. 

You must try to have a different view from the market and other investors.

You must develop unconventional concepts of valuation to properly assess companies operating in non-classical sectors & business models.

You need competitive advantages relative to others  to win. The wider the edge the better.

A conventional value approach is probably not enough as an investment strategy to take you to where you wanna be.

Low multiples of price-to-book, price-to-earnings or price-to-sales do not in itself make a good investment.

A cheap looking stock could be a bad business, and could fail and go bankrupt in a year. No matter how cheap you think you bought the stock at – you will still lose all your money.

On the flip side, a great business that is growing earnings every year with very low capital expenditure required and with monopolistic advantages might not be a great investment either. The price it is currently selling at could be overly expensive for the value you are getting.

The trick is to marry the quantitative part of investing with the qualitative.

A common trap that investors fall into is focusing too much on one aspect and ignoring the other. They want to make an investment so badly, they convince themselves that the price is good enough because the markets are going up and they don’t want to miss the gains to come.

That means they find a stock that fits price-wise, that their brain tricks them into making the quality fit as well, and vice versa.

In other words, if your thesis is aligned with the market’s thesis you have no variant perception. The whole point about value investing is buying something cheaper than it is worth. This could be when markets are rallying for years or dropping for years, it doesn’t matter – because value is market agnostic.

The master stroke here is to work hard enough, and practice enough patience to balance both aspects of a good investment – quality & quantity.

Often and for a long enough time you won’t find anything worthwhile to invest in – you will have to remain patient until you do.

The best thing to do when you can’t find a bargain is to invest in preparation instead. 

Spend time learning about sectors and specific businesses. Learn their ins and outs. Seek to know a business almost as much as its CEO. Have an understanding of where the business is going to be in the next 5 years.

Try to learn on an intellectual level the business model of that business or sector that has piqued your interest.

Do current earnings reflect the true economics of the business? Is the real potential of the business not shown sufficiently in its current financial situation?

Remember, a big part of the market is looking for “bargains”, so they avoid like the plague stocks that seem expensive superficially. This effect causes these companies to remain misunderstood and hence undervalued in the marketplace. 

Maybe that is an opportunity for you to make a good investment. How can you do that?

You need to use second-level thinking to gain an advantage from the general public.

Example One

First-level thinking says this company is selling for 32x earnings and is therefore expensive. 

Second-level thinking says this is a low capex (capital expenditure) platform type business which is in the early days of its growth stages and margins are currently compressed. Maybe there is value here regardless of its high earnings multiple.

Example Two

First-level thinking says the shipping sector is in the doldrums and companies can’t even make debt payments. It’s not the time to invest now.

Second-level thinking says shipping freight rates have crashed and shipping companies aren’t making any money. Fleets are selling for a fraction of their value.

Maybe there is an opportunity here. Start looking for conservatively financed shipowners that will survive this downturn – when the cycle turns you could make a killing.

Example Three

First-level thinking says the stock markets are crashing through the floor because the Fed has signalled that they will start tapering their ultra-accommodative monetary policy. It is a panic out there, stay away from the markets at all costs.

Second-level thinking says investors are fearful across the board due to short-term reasons and they are dumping assets; start looking for high-quality merchandise at written prices. When things cool down as they invariably do – prices will climb up again. 

What I am trying to say is that you haven’t found the goose that lays the golden eggs because you discovered value investing. The game constantly evolves. The obvious is possibly, obviously wrong. Things are never simply good or simply bad. 

The spectrum of risk and reward

You have to look at things not as black and white, but as lying on a spectrum. 

The expected risk/reward lies on that spectrum. As prices and situations change, so does the risk/reward ratio. Your job is to take intelligent bets according to that risk/reward ratio.

Sometimes there are big opportunities, sometimes there are not. Know when is when and be ready.

Your returns won’t come to you because you call yourself a value investor – they will come as a function of the risk/reward you take.

Another way to think of value investing is by asymmetric risk/reward.

In other words, if reward is equal to risk – then it’s not worth the risk.

Instead, what you are actually looking for is positive risk/reward asymmetry.

If upside relative to downside (probability adjusted) is not higher – then you stand a higher chance of losing than gaining. 

Try to integrate second-level thinking with positive risk/reward and you have the ingredients for intelligent value bets.

This can come in the shape of low multiples (P/E or P/B), high (P/E and/or P/B), small caps or mega caps, unknown companies or super famous ones. It can be a property deal, a tech company, or a retailer – it doesn’t really matter.

And no having a stock screener to scan for low multiple stocks with low market values and illiquidity doesn’t mean you’ve cracked the code. That’s not value that’s just the misunderstanding of value.

From the risk/reward choices that you take will stem the results that you are expected to make.

Reverse Engineer the Narrative

Another way to reverse engineer a value oriented investment is to study the narrative on a given company or sector. When for example the market’s narrative is negative for a company because of short-term reasons that you believe are not as important for its long-term success, then after confirming that the numbers work – you probably have an intelligent value bet in your hands.

To summarise, after applying intelligent risk/reward, second-level thinking, market timing or any other tool that you can use at that point in time – what you should get is positive risk/reward asymmetry.

Misunderstanding and how things can go wrong

One of the things that make people give up on investing altogether is that eventually some of your investments can go wrong, you can lose money no matter how much work you’ve done. There are no guarantees here.

It’s critical that investors understand that value investing is not a science, there is no perfect recipe that manufactures without fail the product of investment returns.

There are many ways to place a value bet, this is under no circumstances an exact science and I don’t believe it can be taught – only self-taught.

This reality, that things sometimes go wrong – makes people fearful and cynical of the practice. This could make them abandon its ways and start looking for other routes to investment returns that feel more certain, but in fact carry much more risk.

It is important to keep a cool head and keep your emotions in check, because with all the logic and reason that financial markets operate on, there is an equal amount of craziness and foolishness that go with it.

Thus, great success comes down to the most important differentiators when investing; attitude, temperament and mindset.

Sincerely,

Philo 🦉

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Picks from the archive

Other mindset pieces that go well with this are the one on market agnosticism, the one on endless poker and the one with Rufus the anti-investor!

“It’s not supposed to be easy, anyone who finds it easy is stupid.”

-Charlie Munger

“In the stock market, the most important organ is the stomach. It’s not the brain.”

-Peter Lynch 

“Scientific method seeks to understand things as they are, while alchemy seeks to bring about a desired state of affairs. To put it another way, the primary objective of science is truth,  that of alchemy, operational success.”

-George Soros