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Here is a riddle. Despite countless studies proving the superiority of value investing over growth or indexes, investors do not normally invest for value. Why is that? Don’t they want better performance and greater wealth?
Christopher Browne of Tweedy, Browne in his presentation to the Columbia Business School (Nov 2000) talks about how most money managers and investors are conditioned to track the benchmarks because of the one very basic human fear. The fear of standing out from the herd.
Browne also talks about various other behavioral tendencies people have that doom their aspirations to be a good value investor. For example, the urge to buy and sell when sitting still is normally more profitable. He cites a study of over 100,000 stock trades that found that for these investors, the stocks they sold on average out performed the stocks they bought by 3.4% after a year. Ever thought “the stock always goes up after I sell”. It is not always just in your mind!
You and most other investors are wired to make wrong decisions at critical times.
It is a good read. Please go ahead and download the pdf document and spend some time with it (after you have finished reading this article).
Even practicing value investors fail
Successful value investing requires 2 parts in equal measure: one of knowing the techniques to analyze stocks for value, and the second is the ability to stick to your discipline even when the market and overwhelming investor sentiment screams you are wrong.
Learning the valuation techniques is the easy part. Discipline is hard – it requires a process, patience, and the belief in the process. When you bet against the market as a value investor, you often stand alone. It takes courage to stick to your convictions.
For you will be tested. And often.
Over the last 15 years I have been investing in stock for value, I have learned a few things I would like to share. Perhaps some of these may be unique to my philosophy.
- Buy for the deal, not for the stock price – Most of the analysis I do is based on comparing market value to the intrinsic value. Using the absolute numbers, instead of the per share amounts helps in many ways. For example, it gives me a real feel for the business size and sales that can be compared to the industry. It also helps me remove the influences of such artificial constructs such as share repurchases or new issues. The stock price is pretty much the last thing I look at.
- When the deal gets better, buy more – At one time, NEI stock was down about 40% after they announced future revenue declines due to EMC pulling their business away. However, the thesis for NEI was built on their strong balance sheet and as long as the company stayed profitable, the lower stock price was a much better deal then the price I initiated my position at. One should realize that the market is irrational in the short term and generally reacts to the extremes. I bought more as the stock price touched 40%-50% below the NCAV. Undervalued companies like this attract knowledgeable buyers and the company ended up being acquired, instantly flipping a 40% loss to a 15% gain.
- A stock may stay undervalued for a long time – Nothing might happen for a long long time, and then one fine day, the stock may get discovered. If the company is genuinely undervalued, and is creating more value in the franchise through continued profits, it is calling out for attention that it is bound to get. One might get frustrated waiting for the stock to appreciate. Patience, and being able to do nothing at all when doing nothing is the best course of action is a key skill that very few investors possess.
- There is no hurry – A corollary to being patient but in a different sort of way. If you are doing a due diligence on a stock and are not ready to make a definitive buy decision yet, do not buy. It does not matter if the stock suddenly caught on fire and you think the opportunity might slip away. There will be other ideas. Moving without conviction can be very expensive.
- Where is your guarantee? – So you think that the stock is undervalued and something or other might happen to unlock the value for you? Do you know what that “something or other” is that needs to happen? There are perhaps many different potential catalysts. What is the likelihood of one of these catalysts actually coming into play? How quickly? And how sure are you?
In some cases, you may have a pretty good idea of the catalyst. In most cases however, these will be just different possibilities that you play around in your mind. Building these mental models before you buy the stock, and refining them over time is not just wishful thinking. It helps you take any new data or development in the business and see which of these mental models it fits and that is where you find insights that 99% of the other investors will miss. Your guarantee of gain lies in the fact that 1) you get predisposed to looking for stocks where something good happening is more likely, and 2) you are in a better and more informed position to react when the time comes.
Most value investors fail one or several of these tests. Discipline is hard. Undervaluation does not always guarantee gains and you have to know how and when they will come otherwise you are flying blind. And most value money managers feel compelled to stay fully invested even when it is not a good idea. Most of the success lies in how you approach investing, and independence from institutional constraints is very important.
Despite my calls for patience, it is important to realize that there are times action is required. How do you figure out when it is time to wait and when it is time to act? Experience helps, but more important is to have a well defined process and strategy that you stick with. At times you will make wrong choices, but the beauty of having a process is that it can be refined with experience. What this does is to eliminate those simple mistakes that most investors make that little by little eat away their performance. Just doing this one simple thing statistically gives you an edge over most other investors over time.
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