The most important trait of good value investors

All information on this page is of a general nature.

It does not take your specific needs or circumstances into consideration, so you should assess your own financial position, objectives and requirements and seek financial advice before making any financial decisions.

First of all, happy new year to you all. I hope you all had a nice and relaxing Christmas and New Year break – no doubt it has been very well deserved!!! While most of you have been enjoying the break, I’ve also had the benefit of enjoying three weeks off which resulted in some ‘soul searching’, plans for the year ahead, reflections on how I found myself where I am and what I want the future to look like.

During my time to ponder I wondered how I found myself in investments and markets. It dawned on me that what I love about investments and markets is the multi-disciplined nature of it. As an investor you need to draw on so many different and varied skill sets ranging from business, investment theory, economics, gaming, psychology and science, just to name a few. In my mind there is never a boring day in markets because there is always something happening and something new to learn. Markets help me understand – from many different perspectives - how the entire world fits together.

Whilst the toolbox of skills to draw on is immense and often requires developing, there is one skill above all else that ‘separates the wheat from the chaff’ in my opinion, and that is… DISCIPLINE. Discipline is defined in many ways, but I think the best description of discipline involves three key concepts: training oneself to build habit and control around a particular activity or process. This doesn’t mean making the same investment decisions over and over again, but rather, having a sensible and logical plan of attack to avoid bad investment outcomes.

Below I discuss a number of disciplines I consciously employ when it comes to investing:

1.    Don’t jump at shadows

Recently I’ve witnessed a number of companies announce relatively minor short-term profit downgrades or deferrals of revenue which subsequently led to - in my mind – an unwarranted and disproportionately violent negative reaction to the share price. The long-term trajectory and themes driving the company’s earnings hadn’t changed, yet this minor profit blip saw the market caps of these companies go through the floor. As certain as day follows night, consensus downgrades flowed through and the stocks were ultimately punished even further when investors had time to digest the research notes, which resulted in a self-fulfilling prophecy, where investors reacted to broker downgrades by selling increasingly more stock at bargain basement prices!!!

When assets are priced for perfection (as a lot currently are given the copious amounts of liquidity flushing around in global economies due to Quantitative Easing) and perfection ultimately doesn’t eventuate, typically the downward reaction in price is vicious and overdone as investors head for the exits in droves with little reference to the price they are actually selling at… THEY JUST WANT OUT!!! All companies will go through phases of over-promising and under-delivering for a number of reasons, but what makes great companies is their ability to control the trend by pulling revenue or cost levers (or both), bounce back and regain the market’s respect and admiration. In my mind, these short-term, unwarranted and overly done price reactions are the perfect entrance points into great companies. In my mind when a company I have been following declines by 25%+ it’s like picking up an absolute bargain TV purchase at your local appliance retailer.

When price reactions are overdone on great companies, it is the job a good investor to hold their nerve, not the jump at shadows and to dip a toe in the water.

“Price Is What You Pay, Value Is What You Get” – Warren Buffett

2.    Know what your investment strategy is and stick to it

This is a simple one: know why you’re investing, what you are trying to achieve and how you will achieve it and do not deviate. The only time where it is acceptable to deviate is where your risk or return objectives change due to life events, for example the receipt of an unexpected inheritance may increase your tolerance for risk as your investable asset base may have increased substantially.

3.    Be your own devil’s advocate

As humans we tend to be less critical of our own thinking processes than we are on the thinking processes of others. One way to really dig down on what you are thinking and why you are thinking in a particular way is to be your own devil’s advocate.

As professionals, I’m sure we have all been in meetings where there is that one person who inevitably interjects in a meeting and says “I don’t mean to be the devil’s advocate but…”. To be honest I love these people and we need more of them, but I also understand why they get such a bad rap. By disagreeing with the majority, they are seen to be ‘difficult’, but all they are trying to achieve by challenging the status quo is the best outcome with as little future drama as possible. What is the purpose of a meeting where the attendees all agree with each other? That is not a meeting – that is a lecture. A lot of empirical research shows that unidirectional management styles typically do not result in optimal outcomes. The same concept applies to investing, except the two-way dialogue needs to happen in your own head rather than in the environment of a meeting room.

If we never self-assess or apply critical thinking to our own beliefs, how are we going to invest well or develop as humans? From my observations, there is a tendency of investors to take the ‘she’ll be right’ attitude, until the proverbial ultimately hits the fan. By that time an investor’s capital has already been scorched and permanent capital loss has been inflicted which may be difficult to recover from.

So, as with any purchase, before you proceed take a few moments to ask yourself:

• Do I actually need this or do I just want it?
• What is the highest price I am willing to pay for it? Can I purchase it or a substitute cheaper elsewhere or at some point in the future and do something else with the change?
• Will this purchase actually improve my life, and how?
• What could potentially go wrong and what are the consequences if it does?

4.    Be an independent thinker

If I had a dollar for every time I heard a story from a ‘punter’ that started with “I got this really good stock tip from my mate…” I would probably be on a beach somewhere with my feet up sipping Pi?a Coladas. It’s funny to note that in 99% of cases, you never hear any updates on how said stock has performed because in most cases said company has enteredt liquidation and delisted from the market. I’m not sure I’d be calling these people who inflict permanent capital loss ‘mates’!!!

When I was younger one of the best lessons my parents taught me was that the best way to lose a friend is over money, so I avoid specific personal finance conversations like the plague for just this reason.

What I’m trying to communicate here is: think for yourself when it comes to your investments and don’t follow the pack no matter how good you think your ‘mate’s’ stock tip is. Your investment portfolio should reflect your values, your view of the world and be personal to you.

When I review my portfolio I go through line-by-line and ask myself the following questions:

• Why am I invested in this stock?
• Am I still happy to be invested since the last time I reviewed it? If not, then I sell/reduce. If I become more convicted on the stock, then I top-up. If there’s no change to my view, I continue holding. Investing is not and should not be made out to be rocket science.

5.    Don’t compromise on valuation unless you are being compensated for it or hedging the risk in some way

If you ask anyone “what makes a good investor?”, the answer will ultimately be “someone who gives me the greatest return on my money”. While this is simplistically correct, I would argue that the best investor is one who gives me the greatest amount of return on my money for the least amount of risk. The question then is “well, how do you reduce risk?”.

There are a number of ways to do this:

• Adjust your asset allocation – shifting from less defensive asset classes (equities/property) to more defensive asset classes (cash and fixed income).
• Demand a greater margin of safety or better pricing when investing – what defines performance and returns is a mixture of the starting value, the ending value and income returns earned along the way. The only things we have control over as investors is where we enter and where we exit an investment. Income is determined by the company’s board and/or the returns generated by the company/fund. So, being disciplined and buying at the greatest discount to what you believe the company to be worth (ie. the intrinsic value) and selling at the greatest premium to the intrinsic value, will enhance your returns. It will also reduce your risk and give you a buffer (or margin of safety) in the event that you do mis-time your entry/exit point share price (and all of us will since it is statistically impossible to buy at the absolute bottom and sell at the absolute top).
• Use derivatives to adjust the risk/return profile – utilising hedging strategies can also reduce risk and amplify returns. It’s also important to note that derivatives can also do the opposite (increase risk and decrease returns), so it is very important to seek advice and/or know what you are doing before you venture down this path!!!

6.    Stay emotionally neutral

Investors who miss out on cheap buying opportunities or realise large amounts of investment losses are typically those that are far too emotional when it comes to stock price volatility. They are usually the investors who buy high and sell low, because they are emotionally susceptible to FOMO (the ‘Fear Of Missing Out’) on the way up and they panic sell on the way down. Interestingly, the investment processes used in 'FOMO buying' and 'panic selling' (ie. none) make no reference to the underlying valuation of the company, which probably accounts for a lot of the pain that investors with these traits experience. As I’ve discussed in previous articles, share prices are a function of buying/selling activity and in the short-term don’t necessary reflect the true, long-term value of the company and its opportunities.

As I have previously discussed, I have no idea what will happen in the next 12 months, but - without trying to sound like Nostradamus - I have a good to fair idea of what themes will dominate in the next 12 years, so I invest MORE in certainty and LESS in sentiment.

The following link is great in demonstrating the difference in investment returns if you had’ve missed the top 10 performance days on various global stock markets because you were avoiding the market due to negative sentiment: https://www.fidelity.com.au/learning-hub/understanding-markets/timing-the-market/. The difference in the terminal values of portfolios is quite drastic and in aggregate shows the benefit of buying companies (not even good ones in some instances) on the cheap.

As can be seen from the below chart from Wotherspoon Wealth (2017), the top 10 best days, typically shortly follow the worst performance days, especially in extremely volatile markets such as during the GFC where a lot of these dots are clustered:

In other words, if you invest contrary to market sentiment when times are really bad, recent history has shown you can make better-than-benchmark returns, which is consistent with the old investment mantra of ‘higher risk, higher return’. It’s important to note that historical performance is not an indicator of future performance, but the results are interesting regardless.

7.    Compound your returns

Albert Einstein is commonly attributed with making the quote that compound returns are “the eighth wonder of the world” and “the most powerful force in the universe”. Whether he actually said this is open to conjecture, but one thing that can’t be argued with is the validity and reasoning behind the comment.

It is tempting to spend the money you make, but if you reject that ‘opportunity cost’ of spending and instead invest that money in a compounding way, you can potentially turn a small amount today into a sizeable amount in the future.

The below chart shows $1,000 per year (a relatively minor amount in the context of some spending these days) invested over 50 years (the rough expected working life for a millennial like myself) in different frequencies (annually - $1,000 capital contribution every year, semi-annually - $500 capital contribution every six months, quarterly - $250 capital contribution every quarter, monthly $83.33 capital contribution every month, weekly - $19.23 capital contribution every week and daily - $2.74 capital contribution every day). Due to the effect of compounding, you could turn a $50,000 total capital contribution into multiples of that over time.

Of course, the returns over a 50 year period will fluctuate (rather than stay static as assumed by the below chart) and the outcomes will also change as a result, but the below chart is a good illustration of how a small capital outlay could potentially add up over a long period of time.

The difference in terminal value due to different contribution frequencies is also interesting to note and this effect is amplified where you can generate higher compounding returns on your money over time.

8.    Don’t be lazy… do the work

I always try to keep the best advice until last (just to keep you reading). My final piece of advice is simple but not often heeded – DO THE WORK. Before investing, research the company, the industry, the trends, the market announcements and presentations, where the future is headed and get yourself comfortable that this is a good investment proposition (subject to the prevailing share price, of course).

Analyse the financial statements and ask a few basic questions:

• Balance Sheet – what constitutes the company’s assets and liabilities? How much of the company’s assets are intangibles and what is the risk of these being written down/written off? How geared/leveraged/risky is the company and can I tolerate this risk?
• Cash Flow Statement - is the company generating sufficient cash from its day-to-day operations to fund growth and the dividends it is paying out to shareholders? While these dividends might look attractive today what is the amplitude of the downside risk to them if they are not sustainable? Is the company paying out more dividends that what they generate from operations?
• Profit & Loss Statement – what are the gross and net profit margins the company is making on selling its products or services? What is the trend of the margins – up, down, flat? What will drive revenue/margins/earnings into future? Does the company have scope to decrease costs and by how much?

“If you fail to plan, you are planning to fail” – Benjamin Franklin

Best of luck with your investments and the new year ahead. Happy 2019!!!

Cheers.

Matt

The opinions expressed above are strictly my own.