In our previous article, we wrote about some of the top lessons we have learned from being a Value Investor. These lessons focused on discipline, being contrarian, not always listening to the markets, business value and having a good process. As a reader, we also refer you to our fundamental valuation education articles focusing on DCF analysis, Trading and Transaction Comparables. The articles work as a foundation learning valuation how a “Value Investors” looks and analyses a company. Today we will share further lessons we have learned by being a value investor.
Compounding Returns instead of Trading
A true value investor mind-state is not about trading in and out of an investment or position. This might be true for other types of investors, but for a value-investors, following process and having discipline means buying stocks when they hit the fundamental analysis levels and letting the stock work for you over a long period of time instead of trading out after quick return. In essence, the greatest benefit is to focus on the compounded return which can result in massive gains over a longer period of time. This lesson seems obvious, but for a true value investor, this is one of the main commandments. All the hard and extensive work is done to have an investment over a longer period of time and not trade out quickly.
Warren Buffet has noted that one if comparative advantages is that he has a longer time horizon in his investments than most other investors. That allows him to see clearly true value and the process. Within the institutional investor, environment focus has shifted to more and more short-term performance. This has led to investors who previously traded less frequently are now trading extensively and are more focused on beating their “benchmark” than actually generating good returns. As most of these portfolio managers get compensated not on how they perform (returns) but on how much assets under management, conflict of interest arise. Managers are more focused on expanding the amount of assets they have and less on generating returns. As a value investor, this creates a comparative advantage. If your competitors are less focused on long-term returns and more asset gathering, this gives anyone that targets all their efforts on the long-term, returns will be there.
Price is what you pay – Value is what you get
Price matters. In other words, even though as a value investor one does not trade for the sake of trading, it is important to make an investment when prices hit the fundamental value based on your analysis. The true definition of value investing is to buy a company at a significant discount to value. The larger the discount, the bigger the value and the less the risk one takes.
With that said, there will always be price fluctuations in all types of stocks. As a value investor one needs to be able to distinguish between operational risk and price fluctuations. Often as an investor one thinks just because the share price of a stock goes down the risk of the investment increases when a fair amount of time the opposite is true. As a value investor, the focus lies into assessing and analyzing to distinguish if the price movement is just temporary volatility or actual changes to business fundamentals.
Even if there is uncertainty about short-term price movements of a stock, if you can buy a stock at steep enough of a discount, the margin of safety is enough. In the long run, these price fluctuations don’t matter, the value will ultimately be reflected in the price of the stock. Paradoxically, short-term price volatility that plenty of investors see as a risk, is a blessing for value investors as it gives them an opportunity to snap up stocks they like.
Don’t Lose Money!
One could say this should be the most important lesson of any type of investing. Warren Buffet likes to say the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” As a value investor, the application of this rule does not mean that investors should not incur any losses at all, but more than one’s portfolio or investments within it should lose any principal over several years indicate that the investment thesis on one or several of one’s investments are incorrect. Sometimes value investors talk about they have extremely long time horizon (see the previous lesson) but this does not mean one should get sloppy and accept continues decline and underperformance of any investment.
We have looked further into important lessons of being a value investor. The overarching theme from these lessons has been having a long time horizon. Focus on the compounding effect of long-term returns instead of short-term trading. Remembering that using price fluctuations and massive declines an opportunity to buy stocks at a discount instead of getting too caught up on the short-term fluctuations. Following the main lessons from part one of having discipline and focus on process, by buying when the price reaches the value territory instead of just taking short-term market pricing as given. With all this said, the most important rule of all investing is not to lose money. For a value investor this a long-term concept of just because the price of something goes does, there is automatically more value. As an investor, regardless of what type, one needs to follow the rule of, if fundamentals in ones thesis change negatively one needs to take that into consideration and not blindly staring one’s original thesis. This is another way of stating the famous economist Keyes quote of “when facts change I change my mind”.
We will continue going through the further important lessons and rules for value investing in an additional post.