The term “value investor” has been thrown around endlessly for decades, with prominent proponents like Warren Buffett, Benjamin Graham, Seth Klarman and Walter Schloss. The key principle of value investing is contrarianism — going against the flow of the general markets.
Value investing isn’t some arcane, rare philosophy that’s tucked in some secret section of the Library of Congress that only Nicholas Cage can extract information from. It’s a widespread understanding that can be read by anyone with half an imagination to Google it when they first hear about Warren Buffett’s successes in the market. It’s hard being a contrarian when everyone who reads about value investing wants to be contrarian as well.
The market is made up of people’s perceptions, and the more people read about value investing and contrarianism, the more efficient the market gets – imagine everyone becoming value investors and start investing in “value stocks”, they will essentially push the price up to its fair value. This doesn’t happen all the time, but the fact that it’s harder to find deep value net-nets that aren’t value-traps speaks volumes on how much the market has changed. Stock screeners are free, so quantitatively we can easily find value gaps as much as the next person.
Emotional baggage
True value investing is more on emotions than skill. There are millions of investors out there that are likely to be smarter, more hardworking and armed with machine-learning algorithms with supercomputing power. The only way you as a retail investor can possibly have an edge over those masters of the universe is through intense discipline and emotional control. Machines trading in the market make a ton of money simply because they have an edge over most other investors and traders: the lack of emotions. The machines prey on human emotions to make money.
Value investing is a psychological war against Mr. Market. He comes to you every day with a quote on every stock price imaginable, he is sometimes manic, sometimes depressed. But many so-called value investors often align their emotions with that of Mr. Market. When there’s fear, they too, turn fearful; where there’s greed, they too turn greedy. It’s easy to quote Buffett’s parlance on be contrarian but so few people actually make money doing it. The reason is simply the lack of true emotional control.
Here’s an example: When you believe Stock A has an intrinsic value of $10 and it currently trades at $8, it’s a screaming buy to you. You buy it and hope more people (they make up Mr Market) will finally agree with your thesis. But Mr. Market disagrees and wallops the stock down to $6 – you’re now nursing a 25% loss, but the stock is also 25% cheaper.
You start to question yourself:
“What do all the smart people out there know (Mr. Market) that I don’t?”
“What if I’m wrong and the stock is really bad? Should I cut my losses?”
“What if Mr. Market is really stupid and is giving me an opportunity? Should I buy more?”
“If I buy more, if it goes down further, my losses would compound, maybe I should stick with my current position?”
These questions will be zipping in your head all day long as you question your thesis and sanity. What makes it worse is if the stock is widely covered by the financial media, and you see endless analysts giving bipolar recommendations that confuse you even more.
Those analysts have stellar degrees from top schools around the world and work at prestigious investment banks. They can use Excel without touching the mouse and can value stocks using all sorts of arcane statistical probabilities that you’ve never even heard of. They’re smarter than you, right? So their recommendations must be based on something rational right? The problem is, all of their recommendations whether on the bull or bear side, look immensely pretty and seem rational enough. The key difference between them is simply their future assumptions.
Confirmation bias and hindsight bias
You will then sometimes feel good that this particular analyst from this particular bank has the same assumptions as you do.
“Hey! This smartie with the stellar ivy league resumé agrees with me, he must be right! Right?”
No.
Newsflash: It may even be folklore that equity analysts are almost never right in their predictions. It’s not their fault, it’s the institutions – they’re forced to give a forecast. Why use a terminal growth rate of 1% instead of 0.5%? Is the growth of the economy going to be 1% for the next 100 years? And to think that the terminal value of a stock is a huge chunk of its valuation is largely based on the terminal growth rate.
And if they’re right just one time, they’re treated as some kind of god until the very next prediction goes wrong in a very big way. Just because they’re right once, doesn’t mean they’ll be right all the time.
“There are two types of forecasters: Those that don’t know. Those that don’t know they don’t know.” – John Kenneth Galbraith
The solution? Shut them all off. Many value investing books disparage equity analysts in a huge way, saying true value investors need not listen to what the Street is saying. That’s true, as your emotions will get the better of you when you read a report that’s confirming your beliefs. No one can resist feeling good about themselves when someone seemingly smarter agrees with them. The only way equity analysts are any useful to you as an investor is simply their factual research – if you can resist looking at their assumptions and projections, one can actually learn a lot from an analyst report. That’s why they still have jobs despite being almost always wrong. Use their reports to educate yourself but the moment your eyes shift to the trading call or target price, look away.
The only way equity analysts are any useful to you as an investor is simply their factual research — if you can resist looking at their assumptions and projections, one can actually learn a lot from an analyst report. That’s why they still have jobs despite being almost always wrong. Use their reports to educate yourself but the moment your eyes shift to the trading call or target price, look away.
Going forward
I’m sure you’ve heard quotes like:
“Markets can stay irrational longer than you can stay solvent”- John Maynard Keynes.
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves” – Peter Lynch
The very next thing we think about after reading all these sober quotes is: “So where do I go next?”
The mind games start again:
“Should I buy a toppish-looking stock that has a wonderful business? It has been going up and up for the past decade and it may never correct! But if I buy now and it corrects, I’m the loser!”
“Should I buy this stock after it’s dropped so much? Will it go even lower?”
It isn’t as easy as one would imagine being a value investor. It’s a constant war in your head and Mr. Market will always love to extract tuition fees from you. We can fool ourselves into thinking we will be fearful when others are greedy, or greedy when others are fearful, but endless statistics tell us the same thing:
The average retail investor’s returns aren’t any different from the average hedge fund’s returns: Horrible. They both underperform the market. So you can rest assured that the smart money isn’t as smart as you might imagine. Hell, people sitting on a 100% cash portfolio this year outperformed Bill Ackman. Even Rusmin Ang who shook Ackman’s hand at this year’s Berkshire meeting probably outperformed Ackman! Jokes aside, he’s had a terrible year but he is still a brilliant activist investor that people respect.
The fifth perspective
Apart from reading up as much as possible to learn as many things as you can about the industries, sectors and companies that comprise the global economy, one should recognize the fact that there will always be someone out there smarter and more hardworking than you in doing his homework (or due diligence), but it doesn’t mean that he’ll be right. The only difference between you and him is emotional control and humility.
Learn to control your emotions as much as possible – it wouldn’t be an easy task. It takes a highly disciplined mind to even control an impulse. It’s as tough or even tougher than quitting smoking or not using your smartphone for hours on end. A steely, emotionless but rational approach to investing is what gives you an edge over others, not wits.
You’re probably sick of quotes but here’s one that will last for an eternity and will always be relevant in any kind of market condition:
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be intelligent” – Charlie Munger
As long as you acknowledge the reality that you’re not the brightest person in the markets, nor have the ability to predict the future, and simply humble yourself into trying to stay (with great discipline) within your circle of competence, you would be on the high road to being a value investor. Being contrarian is a lonely endeavour, you can have the market move against you and stay that way for years while people around you embrace in euphoria, making tons of money off stupid ideas — this is what irritates and destroys discipline in most budding value investors.
You must have the mental fortitude to be able to stomach all that and still move on investing in an emotionless, near-robotic manner which would defy traditional human instincts of fear and greed. This is the very first step in becoming a value investor.
Steel yourself, human.
