Education

Value Investing – Top Lessons Learned from being a Value Investor Part 3

In this third part of top lessons learned as a value investor, we will pick-up on the main lessons we learned from part 1and part 2. Building on the direction of long-term focus and compounding returns are things we will address on top of the cardinal rule of risk management. Value Investing requires a lot of patience as we will address below.

Stable consistent returns are better than spectacular volatile returns

We discussed in earlier articles that the most important lesson is not to lose money. If one experiences big losses in a situation, it will be much more difficult to recover and have compounding returns for the whole portfolio. A big loss can basically wipe out all the hard work on disciplined stable returns one has build-up with other investments. As an investor, the likelihood of doing well is much higher when with stable and consistent returns and limited downside than situations with massive gains but with substantial risk for one’s investment. For example an investor that has annual returns of 16%/year over 10 years earns more than an investor that gains 20%/year for 9 years and then loses 15% on the tenth year. Value investing is like the old fable of the Hare and the Tortoise, “slow and steady wins the race.”

Margin of Safety – Prepare for the Worst

All good value investors know that they cannot get every decision right. Even though we strongly talk about avoiding to lose money as the most important lesson, there will be situations where one is wrong, or something unexpected happens and losses hit. The best way to avoid or minimize these type of situations is to plan ahead both on a portfolio level and single name investor basis. There are various forms one can do this.  For example, by buying out of the money provides options in case something happens. One must be willing to forgo short-term returns and have “insurance” against the unexpected happening. Often in the financial markets, there is talk about “4, 5, 6…etc sigma-events”. This means that something based on models would only happen once every thousand years. Interestingly enough, it appears that these type of “model-events” tend to happen fairly often. The 2008 financial crisis being the prime example of this. As an investor, one thing is certain, there are going to be unexpected negative surprises happening all the time. The question lies in how one prepares for them.

Another way of preparing for the worst – is buying assets that are trading at a substantial discount to their underlying value. In other words, buying a bargain. By buying an asset that trades at a significant discount is an indirect way of preparing for the worst. There is a much smaller likelihood that a surprise negative event will cause massive losses on something that has already been hit hard than a stock that trades close to highs. Also, the margin of safety is an insurance against human error, bad-luck, massive macro events having a negative impact. Value investors actively include the margin of safety in their investing process. Not only are we humans imperfect and produce mistakes, but the world is an uncertain place and negative surprises happen all the time. Insure yourself through protection and buying assets with a large margin of safety.

All focus on process and outcomes will come – Not the other way around      

Often we hear investors both professional and non-professional start the conversation about their investing in stating how much they want to make a year. For example, stating you want to achieve 20% yearly returns without addressing how you will achieve it. Unfortunately, returns are not a function of how hard you work. Within investing, you won’t make more money by “thinking more.” For an investor, all he/she can do is to focus on having a disciplined process and over time returns will come. Another way of saying this is tying it to our margin of safety and preparing for the worst lesson. As an investor, you cannot plan for how much return you wish to return. But you can target how much risk you can take as part of your investment process.

Patience – wait for the right pitch

As an investor, especially as a value investor, one does not have to do anything. Often just doing nothing and sitting and observing is the best action possible. An important lesson is sitting back and studying various companies through different cycles. Do your analysis and invest at the right time. If you do not fully understand the business or the underlying risks with it, just because it looks interesting there is no need to invest. Have patience and make sure you understand the business and invest at the right time. There is no need as a value investor to be fully invested at all times. Most institutional investors such as mutual funds feel forced to be invested at all times, as they are not getting paid to just sit on cash. As a value investor you have none of these problems. As a retail investor, you have no obligations to be fully invested at all times and swing at every pitch. Instead sit back and study and swing when the moment is opportune. When one does not feel the pressure to invest the best opportunities arise. Avoiding premature investment in a business can be detrimental as well.

Often in bull markets, value investors don’t really see any good bargains as stocks trade at their highs. In those situations whilst most market participants talk loudly, value investors just sit and observe. On the flip-side, during massive downturns and market panicky markets, plenty of opportunities show-up. As other investors are throwing out the baby with the bathwater, these are the period’s value investors do most of their investing. The number of undervalued stocks and the level of their undervaluation increases in a bear market, whilst there is an inverse relation of this in a bull market.

Again we come back to the notion of discipline and process. If a value investor has good discipline and follows a well-thought-out process,  bad pitches in expensive markets can be avoided. And one is prepared for snapping up bargains in cheap markets.

Conclusion

In this part, the main lesson we wanted to convey is having patience and waiting for the right moments to invest. Furthermore, we broached the idea of preparing for negative surprises in whatever shape or form. We as investors are not perfect and there will always be negative surprises. One can either buy insurance to avoid these situations or buy with a greater margin of safety to provide a good cushion when things turn.

In the next installment, we will further discuss the valuation process for a value investor.