The following is an un-edited excerpt from the last newsletter I sent to my Premium members. I hope you find this a useful philosophy to adopt in your investing. It works for me and should work for you as well.
There are a couple of points in my investment philosophy I want to bring out. Unlike other value investors, I do make occasional macro-economic bets. These are often based on powerful trends, such as demographics, urbanization, etc. which are not easily reversed. The idea being that as long as long term trends stay intact, short term volatility can serve up great opportunities. The focus though is always on identifying great opportunities.
Odds: Great opportunities are defined by overwhelmingly favorable odds
You can judge long term trends accurately, and identify the companies that will benefit from these trends correctly. However, you may still end up losing money on your investment if you end up over-paying for the stock. The reason is twofold and is best illustrated by the following
1. In the long term, stock prices track the intrinsic value of the company
2. You may end up holding the stock for a long time to profit, and there is an opportunity cost to the time
One of the ways to visually look at this is to consider a sine wave. In this plot below, I have modified the wave by adding a random number at each point to more closely resemble a stock price movement. It is assumed that we have picked the right company to invest in that grows its intrinsic value over time (although probably not linearly as depicted by the black line). Sometimes, the stock price (the red line) is below the intrinsic value, other times it is above. When the price is below, the stock is undervalued and when the price is above, you will overpay for the stock if you purchase it then.
Learn more: define deflation
If you buy the stock when the price is in the region marked A, you are more likely to make a profit and quickly than if you buy the stock when the price is in the region marked B. The potential for your holding sitting at a loss for an extended period of time is also less.
In short, buying an undervalued stock makes the Odds strongly in your favor. If we were to put this in betting terms it would be something like: “Heads I win, Tails I do not Lose Much”. There will be occasions when your investment thesis turns out to be wrong, but they will be exceptions rather than rule.
Please note: While this might look very much like technical analysis or charting, it is not. We are looking at long term macro trends and intrinsic value growth, not short term investor behavior to make our decisions.
Learn more: stock vocabulary
Ends: Why exit a position in a good company at all?
If you have been a member for some time, you would have noticed that I typically end my position when the stock price ends up in the Region B, even though I may still be very positive for the company in the long term and would readily agree that the stock price will potentially be much higher in 5 years’ time than it is today.
In majority of cases, it is better to find region A in another stock, or even hold cash than to continue holding a stock with price in region B.
The opportunity cost of lost time when you are waiting for this stock to be profitable is enormous. While markets may be rational in the long term, in the short term irrationality in the prices for a stock may persist for quite some time (in either direction). It is almost always better to redeploy capital in another better valued security (or cash). Besides, it makes for a good discipline to stick to your valuation targets for buy and sell.
If you focus solely on the valuations and fundamental research, over time you will do well without having to worry about timing the market or the stock price. It happens naturally.
Why cash is a better option than holding on?
It is true that cash does not earn you much, but it gives you an option to buy an undervalued stock should you find one in the next weeks or months. If you do not want to go to cash and keep holding the stock, you may very well end up selling the stock at the wrong time with less profits and/or may not be able to take advantage of another undervalued opportunity in time. Do not underestimate cash – it may not earn much by itself, but it more than makes up for it by giving your portfolio the flexibility you need to maximize your returns. Being fully invested at all times is neither practical nor desirable.