VALUE INVESTING: I Don’t Manage A Portfolio, I Invest!

VALUE INVESTING: I Don’t Manage A Portfolio, I Invest!

Value investors often appear inactive, but don’t let the lazy exterior fool you--their minds are burning calories at a rampant pace. In a recent 2003 book called The Five Keys to Value Investing, J. Dennis Jean-Jacques lays out an overall philosophy of value investing, which includes, as the title implies, five essential aspects:

- Business
- Value
- Price
- Catalyst
- Margin-of-Safety
- The Mind of the Value Investor

What questions do I ask someone when they give me a stock tip. These questions always rush into my mind...

1. Is this a good business?
2. Is management top-notch and acting in shareholders’ best interests?
3. What is the entire business worth?
4. Is there a catalyst to move the market value closer to the intrinsic business value in the next year or two?
5. How’s the balance sheet and cash flow statement looking? Would I have a large margin-of-safety if I bought at current market prices?

By the time I get to this question (usually asked silently in my head), the poor fool giving me a hot tip is already exhausted and sorry they ever met me.

Value investing is not a technique, it is a philosophy. It is a way of life. In fact, value investors approach what they do inside or outside the world of finance in the same way--taking certain criteria to make a decision, while demonstrating emotional discipline along the way. These patient thinkers tap all available resources to make a judgment call, but follow no one source. They do their own work. Value investors trust their abilities, their instincts, and their philosophy. Their investment style is an extension of their unwavering personalities. They don’t act instinctively, but strategically.

The essence of a value investor is this simple...

GOOD BUSINESS + EXCELLENT PRICE = ADEQUATE TOTAL RETURN OVER TIME

While many value investors have a variety of approaches and investment criteria, what binds them together are three basic characteristics:

(1) they exude emotional discipline,

(2) they possess a robust framework for making investment decisions, and

(3) they apply original research and independent thinking.

Value investors also realize that investing is a journey, sometimes over a rather bumpy terrain. But, the decision making must be a patient process, requiring hefty amounts of perseverance and commitment.

Emotions include feelings of fear, anger, greed, pride, envy, and regret. Discipline is training yourself to act according to a predetermined set of rules. Investors are human, and therefore imperfect, not machines able to analyze data and make buy and sell decisions in a vacuum. People are emotional creatures who are driven by fear, greed and gambling instincts--usually with a poor sense of probabilities and statistics.

There are three basic characteristics of people who lack emotional discipline:

1. They often believe what they want to believe, and tend not to take into account what the facts dictate.
2. They are short on courage and at time slack conviction to act on their own information.
   
3. They are too short-term oriented.
   

Legendary fund manager, Peter Lynch has discussed how investors continually pass in and out of three emotional states: concern, complacency, and capitulation. He explains that the typical investor becomes concerned after the market has dropped or the economy seems to have faltered, which keeps this particular investor from buying good businesses at excellent prices. Following this logic, after the investor buys at higher prices, he or she gets complacent when the stock continues to rise. This is precisely the time to review the company’s fundamentals. However, this type of investor will generally let it ride. Then finally, when the stock market falls on hard times, and the price falls below the purchased price, the investor capitulates and sells on a whim.

Even a few so-called long-term investors are only so until the next big drop in stock prices. There is no such thing as long-term investors, if they do not develop a tolerance for pain and the ability to ignore the market’s panic. You hear cynics say, A long-term investment is a short-term trade gone bad. True long-term investors are fewer than most believe, as emotional discipline is in short supply, even among professional money managers.

Seven Fundamental Beliefs to help build emotional discipline to become a Value Investor:

#1: The world is not coming to an end, despite how the stock market is reacting. Investor sentiment has a more pronounced impact on stock prices than fundamentals in the short to intermediate-term. In the long-term, however, fundamentals always prevail. Throughout the history of capitalism, markets have survived and fluorished after times of crisis--world wars, depressions, recessions, terrorist attacks, etc. Most recently, after 11 September the DOW fell 1,300 points in 5 days, but within six months recovered the entire loss.

#2: Investors will always be driven by fear and greed, and the overall market and stocks will react accordingly. This volatility is simply the cost of doing business. Fear forces stocks below intrinsic value, while greed allows it to exceed intrinsic value. Value investors take advantage of emotional investors.

#3: Inflation is the only true enemy. Trying to predict economic variables and the direction of the market or the economy is a waste of time--focus on businesses and their values, and remember Belief #1 above. Inflation has a devastating effect on investors and there is little one can do about it. Buffett says, The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to sumply consume capital. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker--but not your partner.

#4: Good ideas are hard to find, but there are always good ideas out there, even in bear markets. The stock market is really a misnomer. Rather, there is a market of stocks. Any individual investor can do well regardless of the overall market. Value investors are bottom-up investors, looking at one business at a time. Our WS8 portfolio, for example, used this bottom-up approach to achieve over 20% total returns in 2001 and 2003 while the STI index (the market) fell by over 10% each year.

#5: The primary purpose of a publicly traded company is to convert all of the company’s available resources into shareholder value. As shareowners, your job is to make sure that this happens. Companies are not only going concerns, they are also resource conversion organizations--converting all of the company’s available resources into shareholder value. If this conversion does not take place, then the company is better off shutting its doors and going private. The best businesses are managed to convert resources--people, capital, brand, property, plants and equipment--into shareholder value. Management is the key.

#6: Ninety percent of successful investing is buying right. Selling at the optimal price is the hard part. As a result, value investors tend to buy early and sell early (or never). The market is very consistent in offering investors opportunities to buy good businesses well below their intrinsic value, and at times the opportunity to sell above that value. For investors to take advantage, they must have in place a framework to know exactly when to buy and sell. Of course, for the value investor, the ideal purchase is one that can be held forever!

#7: Volatility is not risk; it is opportunity. Real risk is an adverse and permanent change in the intrinsic value of the company. The value investor disregards day-to-day movement of the general market. The fair and intrinsic value of a business does not fluctuate as often as its stock price. Benjamin Graham is noted as saying that the market is there to serve you, not to guide you in making decisions. Real risks are the risks to cash flows and the underlying economics of the business, and they are magnified or reduced according to your initial purchase price.
Warren Buffett, obviously our favorite value investor here at WS, clearly outlined his investment criteria in a 1998 issue of Outstanding Investor’s Digest.

Buffett said, Our criteria for selecting a stock are also our criteria for selecting a business.

1. First, we’re looking for a business we can understand--where we think we understand its product, the nature of its competition, and what can go wrong over time.

2. Then, when we find that business, we try to figure out whether its economics--meaning its earnings power over the next five or ten or 15 years--are likely to be good and getting better or poor and getting worse.

3. And we try to evaluate its future income stream. Then we try to decide whether we’re getting in with people who we feel comfortable being in business with. And finally, we try to decide on what we think represents an appropriate price for what we’ve seen up to that point.

Michael Price is another legendary value investor. A reporter once asked Price what an investor should look for when considering what companies to buy. Price responded, First, a company selling at a discount from asset value. Second, a management that owns shares. The more the better. Third, a clean balance sheet--little debt--so there is less financial risk. It doesn’t work to buy things that are highly leveraged. If you do these three things, you’ll do fine.

The reporter interrogated Price a bit further by asking if his approach was the same as Warren Buffett. Price abruptly replied, No. The mindset is similar. But Buffett is different. He can identify businesses with very unique franchises. We’re not good at that. We’re not. We look for value.

Will your value investing methods be exactly like Warren Buffett or Michael Price? Not likely. For one thing, we invest in Asia, a vastly different market, business, and cultural environment than these accomplished American value investors. Nevertheless, you will be wise to stay within the boundaries outlined by these legends as you add your unique screens and valuation metrics--and ways to remain emotionally detached-- to come up with your own definition of value investing.

Sage@wallstraits.com



Credits: Much of the content of this article was extracted from a new book by J. Dennis Jean-Jacques, The 5 Keys to Value Investing, McGraw Hill, 2003, ISBN 0-07-140231-4. It will be added to our Sage Library soon.