Stock Value

Picking great stocks at bargain prices is the easy part of value investing.  The difficult part is overcoming the emotional & psychological barriers.  Success in the stock market requires both.

Everyday you’ll be assaulted both internally and externally by forces urging you to make poor investment decisions.  Recognizing these hurdles to successful value investing is the first step in overcoming them.  Let’s explore some.

Human Nature

As humans, we feel excitement and exhilaration seeing others make money. Our natural reaction is to jump in at market peaks to avoid being left out. This is exactly the worse time to be buying stocks. Warren Buffett endlessly repeats the phrase: “Be fearful when others are greedy. Be greedy when others are fearful“. Evidently, few of us can.

Part of the problem stems from the our ability (or weakness) to recognize patterns. Humans have a natural tendency to see patterns in data, regardless of whether a true pattern exists or not. When we see stocks steadily rise for a period of time, we tend to think that a pattern has emerged. We then become greedy and buy into a bull market near its peak.  As our investments lose money in bear markets, we experience fear at the thought of even further losses and sell stocks at market bottoms.  Obviously, our brains are not naturally built to withstand the tortuous ups and downs of the stock market.

Identifying our natural instincts and tendencies of fear, greed, envy, pattern seeking and group mentality, helps us to recognize when we’re basing our decisions on gut reactions rather than facts and reasoning.  Simply being aware that our emotions are affecting our thinking gives us the chance to overcome them.  This is probably the most important factor in making wiser and more profitable investment decisions.

Further reading: Can We Turn off Emotions when Investing

Effort Required

We are lazy. But, this is good. It means we strive for efficiency. We seek the greatest gain with the least effort. This is a facet of human disposition that also, unfortunately, continues the existence of ridiculous get-rich-overnight “investment” schemes and countless other false avenues to instant fortune. Many among us are optimists to the point of fallability, believing that riches can be had without the necessary skill nor work.

Successful value investing requires at least some time and effort. There’s no escaping this. To discover the intrinsic value of a company, whether or not it represents a great value at a reasonable price, requires knowledge and how to apply it.  The Stock-Value.com reading list is the good place to start for knowledge.  Applying that know how can range from a quick glance at the multitude of ratios and figures available on Google Finance or Morningstar, to reading countless annual reports in detail, Buffett style, to screening for value stocks using software and applying Excel worksheet based research into promising stocks.

Forming a clear, concise picture of a company’s future profitability and stability requires the digestion of many facts & figures while not overlooking the industry and overall economy in which it operates. And it appears that you cannot outsource your analysis nor rely on the broken system of ratings agencies to help. The care with which we put our money to work is the defining difference between investment and speculation.

Wall St.

Wall St. brokers are middlemen whom earn money from trading, not investing. They profit regardless of whether stock trades are profitable or not. If we believe that humans seek the greatest profit, then Wall St. wants you to trade as much as possible. As evidence of this, look at the following E-Trade sign-up page and note how the language is aimed at encouraging hyperactive trading:

Care to know how many times the word “investment” is used on that page? Zero. And the word “trade“? Thirty seven times. (The screenshot doesn’t contain the entire page). I’m not sure how much responsible investing they’re pushing, but you can certainly “Supercharge Your Trading” with “Speed, Value, and Performance” using “Power E-Trade Features“. Is this a 1970’s comic book or an investment brokerage?

Buffett, in his 1988 chairman’s letter, stated “[on great investments], our favorite holding period is forever“. Wall St. and the average value investor clearly have divergent goals. Keep this in mind: Wall St. is your pusher, not your friend.

Misappropriated Academia

Academic research has a tendency to be adopted by Wall St. when there is a way to profit from it, regardless of whether the research is meant to be applied to the real world or not. Remember that Wall St. makes its money from moving money. Anything that increases the flow of funds is fair game.

Risk management and “risk adjusted returns” are some relatively new financial marketing terms being employed Wall St. to ease investor concerns and to open their wallets. By simply having a way to measure and quantify “risk”, investors suddenly feel safer, resulting in much larger and riskier bets being based on possibly false assumptions of safety.

Citigroup’s downfall is a prime example of the dangers in Wall St. abuse of academic research.  Ironically, Citi listened to its own propaganda machine, making itself exhibit A in the fallacy of risk modeling, being the latest bank to be rescued by the U.S. government due to its enormous losses on U.S. housing market which they blamed on poor risk management practices.

In October 2007, just over a year ago, Citigroup stock was worth $46 when they began to admit that their risk management was poor, but defended their weak investment results saying they were “within the range of potential outcomes. But obviously at the very far end of that range, as they relate to risk limits.” A year later, with its stock at $3.77, Citi was continuing to suffer massive losses on housing related investments, which their stock price reflected. If their risk analysis from a year ago said that they had “hit the limit”, why were they continuing to suffer such huge losses? Obviously, their risk analysis was a complete sham, allowing a greed fueled binge on ultra risky real-estate investments.

Shall we name some others that suffered the same debacle-level “risk adjusted returns”? Lehman Brothers, Wachovia, Washington Mutual, Country Wide, Bear Stearns, AIG, Fannie Mae, Freddie Mac, Fortis, Royal Bank of Scotland, Iceland. This list goes on and on.  All of these parties, investment banks, retail banks, small countries, surely had risk management teams crunching numbers that justified their investments in troubled assets.

The lesson here is to be wary of making investment decisions based on theoretical research that one doesn’t understand or worse, is misapplied.  Know your limits.  Be cautious.  Stay within your “sphere of competence” as some have put it and know that straying outside of this area is tantamount to speculation.

There are some academic theories which expound intelligent investing as futile; Modern Portfolio theory and efficient market hypothesis claim that you cannot beat a diversified basket of goods picked more or less randomly.  Again, don’t take these academic postulations too far.  There are obviously some individuals who have proven themselves capable of “beating the market”.  Below is one example.

Modern portfolio theory can be summarized as: “outperforming the market can only be done by taking on greater risk”. Over time, bearing additional risk should mean suffering additional losses (otherwise, it’s not really a risk then, is it?), making up for any short term outperformance of the market. This in real-world terms would imply that consistently earning returns greater than the S&P 500 index, is impossible. (The S&P 500 index quite accurately tracks the performance of the market as a whole). Yet, there are a number of value investors who have outperformed the overall market over a span of decades.

Peter Lynch managed to earn a 25.8% gain over 20 years as the manager of Fidelity’s Magellan fund. The S&P 500 in contrast returned only 8.03% during the same period. Over that twenty year period the S&P, at 8% growth, turned $10,000 into $45,492 while Peter Lynch, earning nearly 26% per year, turned $10,000 into $783,307. It is true that our timeline isn’t infinite, so, at some future time, these successful investors may end up reversing their outperformances with greater than average losses. But, so far, there appears to be evidence that modern portfolio theory remains just that, a theory, not a law. Some other investment records of note: Royce Select 1 Fund, Berkshire Hathaway’s BRK.A.

Further reading: The Heresy That Made Them Rich

Sensationalist Media

Here’s a sampling of news sources from Friday, Dec. 5, 2008. The news is the same, but it’s the delivery that is different:

Media makes money from advertising. The larger the audience, the pricier the ad space, the greater the revenues for the publisher. Thus it is profitable for media to draw in the largest audience. The same information can be presented in ways that illicit stronger emotional responses. The greater the emotional response, the greater our captivity. The more we read, the greater the ad revenue. It’s a business model that coincidentally has detrimental effects on making calm, clear investing decisions. When you see a bloodbath on Wall St., your natural fight or flight response tells you to cut your losses and run, even though your chances of profiting from market lows is greater than ever.

Following market news and related media too closely will weaken your resolve against the forces of greed and fear which separates investors from speculators. Be careful of how much time you spend exposed to sensationalist media.