One of the best mental models to use in your investing journey is one of detachment. To quote The Oracle:
“I buy on the assumption that they could close the market the next day and not reopen it for five years“
The real test if you’re truly investing or not, is to abide by the above quote. This mental model is also a check on how certain you are on a company before you take a position. If you’re having doubts, don’t buy. And if you truly think of yourself as a business owner, why should you care what the market does anyway?
Did You Remember to Invert?
As intelligent investors, we always want to invert our investment decisions. We want to spend most of our time thinking about the downside. The (almost) perfect opportunities are rare, but when they do appear, they usually have the following characteristics:
- A business you understand, preferably with values according to your own.
- Has able and honest management, incentivized to do the right thing.
- Has an identifiable moat, earning above average returns on invested capital.
- Is selling at a cheap price in relation to conservatively estimated intrinsic value.
Most of the time, the market knows these superior businesses, and prices them accordingly (at premiums). I mentioned earlier that these situations are almost perfect. Even the best opportunities will usually have some concern. You can call this phase of the investment process the bias-check phase. The inversion process is an excellent filter; Instead of thinking what can go right, you need to deliberately look for scenarios where things go wrong.
Price Rules Everything Around Me
Wu-Tang’s hit C.R.E.A.M (Cash Rules Everything Around Me) should apply to the balance sheet. But when thinking of stocks, the intelligent investor should hum to the tune:
“Price Rules Everything Around Me, PREAM.”
A great business does not equal a great investment. You can make above average returns from a wonderful business, an average business, or even a below average business. The biggest differentiator to your returns is the price you pay. Even after you’ve detached yourself from the market and honestly assessed the downside, we still have to deal with the unknown.
Understanding price and its relation to value is what gives us a margin of safety to the unknown, and to scenarios where things go wrong. The longer you invest with a value mindset, the more you realize that the true patience test is to remain price-disciplined. More often than not, you will see many situations that look like opportunities, but the price isn’t quite where you want it to be. Beware! This is the danger zone! Your biases may start to creep in. Your mind can start tricking you into thinking about all the potential upside. Yes these upsides may exist, but if there’s no margin of safety, the risk is not worth it.
Accept the Entry Fee
Time and time again, you’ll come across stocks you almost bought, but didn’t because whatever reason. Next time you look, the price has doubled. All market participants will go trough this. You just have to accept it as a natural occurrence in markets and as your psychological “entry fee” to this world. A much less talked about scenario, however, is that it also applies the other way around. The same situation, only this time the price halved. But we don’t focus on these as much as on the ones that “got away”.
Are brains are wired towards survival. We naturally want to avoid the things that make us uncomfortable. This behavior is reflected in the stock market. People gravitate towards that which has gone up, and detest that which has gone down. In order to get different results than the market, you have to do things differently. This means gravitating towards things that have gone down in price. Not up. To be clear, I’m not saying you can’t make money in stocks that have shot up. But the task of evaluating the margin of safety becomes more difficult.
If you buy expensive stocks, more things need to go very right in order to generate superior returns. And you truly must have superior insight into the situation compared to Mr. Market. The fellow is already bullish about the same company. If you go into these situations, you need to answer the question: “How and why is my superior insight not reflected in the already high stock price?” A traditional free cash flow based valuation will not indicate a bargain and growth has to be exponentially high for the foreseeable years. Even if there is growth, but it doesn’t materialize the way Mr. Market is expecting, he tends to be unforgiving in these circumstances.
Innate or Learnable?
Despite being rooted in solid logic, only a minority invest with a value mindset. This is indeed strange, since in every other aspect of our lives, we want the most value for the least amount of money. Why is this? Is there a value investing “gene” or is rational market behavior learnable? This question was asked Seth Klarman in an old interview, and he believes in the former.
I think the answer lies in a mix of upbringing, surroundings, life experience and personality traits. The topic remains way too underdiscussed, and will be the focus of my next post.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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