Today's column is a continuation of my introduction to the basic principles of value investing, which I labeled the 10 commandments of value investing. I've already touched on the first three, the last of which was the importance of learning to estimate the true value of a business. Now, we'll hit commandments four through seven, and then I'll be back with the final installment in my next column.
IV. Know Your Circle of Competence
Warren Buffett has strongly emphasized the concept of limiting yourself to those situations in which you have a strong circle of competence; an idea introduced by another great investor, Philip Fisher. "You can't make money in stocks unless you understand the business," is a common Buffett quote.
In a presentation at Wharton in 1999, Buffett offered the following observation:
I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that's a seven- or eight-foot bar that I can't clear. There are people who can, but I can't. The fact that there'll be a lot of money made by somebody doesn't bother me really. There's going to be a lot of money made by somebody in cocoa beans. But I don't know anything about 'em. There are a whole lot of areas I don't know anything about. Different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence.
Of course, nobody is born with a circle of competence, and value investors should always be working to slowly widen their circle. The best way to expand your circle is to identify an industry or market sector in which you have a passionate interest, and to research the major players in that industry. Eventually, you will acquire a strong working knowledge of the dynamics of that industry, which will enable you to spot investing opportunities. If after a period of concentrated study, you come to the conclusion that you don't possess a natural affinity for that industry or sector, you can go on to something else until you find one that clicks for you. Every investing idea you consider offers a chance to widen or deepen your circle of competence, whether you act upon the idea or not.
V. Demand a Margin of Safety
In The Intelligent Investor, Benjamin Graham ventured the motto "margin of safety" in an attempt to "distill the secret of sound investing into three words." In 1990, Buffett wrote, "Forty-two years after reading that, I still think those are the right three words." In his famous essay entitled The Superinvestors of Graham-and-Doddsville, Buffett wrote:
You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.
There are two ways to ensure that you have a margin of safety. The first is to make sure that your estimates of the fair value of a business are conservative; the second is to demand a discount from even the low end of the fair-value range. The size of the discount you demand will determine the number of opportunities available to you. Two well-known managers, Mason Hawkins of Longleaf Funds and Bill Nygren at Oakmark will buy stocks at no more than 60% of their estimated fair value.
Unfortunately, the stocks of good businesses are not always available at prices that offer a significant margin of safety. Nevertheless, opportunities do present themselves, but they require that an investor be patient and prepared to seize them when they do appear.
VI.
Wait for the Perfect Pitch
That brings us to the next core principle: waiting for the perfect pitch and then having the conviction to smash it out of the park. Seth Klarman addressed this analogy in Margin of Safety:
A long term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They have infinite patience and are willing to wait until they are thrown a pitch they can handle - an undervalued investment opportunity.
By the way, I believe that having the patience to wait on those fat pitches is an area in which the savvy individual investor has an edge over most professional money managers. The pressure on professional managers to act, especially when stocks are going up, was beautifully summed up by Buffett at the 1999 Berkshire Hathaway annual meeting:
"The stock market is a no-called strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, "Swing, you bum!"
The pressure to act, whether it is internal or external, must be resisted until a compelling investment idea presents itself.
VI. Make the Market your Servant, Not Your Master
Because of the auction nature of the market, prices are set by the marginal buyer or seller, not the most rational. Short term supply and demand imbalances can create tremendous opportunity for the value-based investor. Benjamin Graham introduced the wonderful parable of Mr. Market, a manic-depressive fellow who often "lets his enthusiasm or his fears run away with him." Rational investors do not look to the market for guidance, only opportunities. Here's another great excerpt from Margin of Safety:
In reality the market knows nothing, being nothing more than the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market's periodic irrationality have a good chance of enjoying long-term success.
I'll leave off with this warning from Warren Buffett's 1987 letter to shareholders of Berkshire Hathaway
Like Cinderella at the ball, you must heed one warning or everything will turn to pumpkins and mice. Mr. Market is there to serve you, not guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game.
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Guest columnist Zeke Ashton has been a longtime contributor to The Motley Fool and is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. Please send your feedback via email . The Motley Fool has a disclosure policy.
