3 Things to Avoid So You Don't Blow Your Money

Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at Columbia University's Graduate School of Business, Greenwald has also authored multiple books, including Value Investing: From Graham to Buffett and Beyond.

Greenwald describes the three ways value investors can permanently impair their capital. Avoid them, and you're left with the macro risk. While you may not be able to predict the behavior of the macro environment, you can recognize and account for its potential effects.

Full transcript below.

Matt Koppenheffer: In terms of the changes that have taken place since the financial crisis ... before the financial crisis and still through today, there are a lot of value investors that appreciate that the macro environment makes a difference to how their investments are going to perform, but at the same time say, "Well, we don't know how to predict the macro environment."

And yet, there are a lot of investors that are now saying, "You're crazy to not try to predict what's going on in the macro environment." Has it changed? Is it different now?

Bruce Greenwald: I think that, for the sensible value investors, trying to predict the macro environment is not what they do. I think what they've done is they've adjusted their risk management techniques to recognize what the macro environment can do to them.

Let me talk about what is the value approach to risk management. It starts not from variance. Variance assumes, by the way, that upward and downward movements are symmetrical, and we know they're not.

It also assumes that, over time, things are serially uncorrelated so if it drops this period -- if you have a 5% price drop -- that's the new base, so essentially all movements are permanent movements, and we know that there's reversion to the mean, especially in individual stocks, which is what value investors depend on to some extent.

The value approach to investment is to protect yourself against permanent impairment of capital. If you think about that, there are three basic ways to permanently impair your capital.

The fastest way to do it is to pay $100 for something that's worth $50. That's why the biggest value technique for risk management is margin of safety. It's to make sure, as sure as you can be, that you're paying less than what the long-term value of that asset is. That's really what they depended on, always, in the first instance. It's what Ben Graham talked about.

The second thing is that what will convert a temporary loss into a permanent loss is if you have to sell out or you go bankrupt. Leverage, at either the company level or the portfolio level, is something you want to avoid.

Koppenheffer: That's getting back to that permanence of capital.

Greenwald: Avoiding permanent impairment of capital.

The second thing I think value investors look for is relatively clean balance sheets and/or stable enough earnings to support comfortably any debt that's on the balance sheet, and not leveraging themselves up too much.

The third is diversification. Not full diversification, but you're going to make mistakes in valuation. You're going to be wrong, so you don't want to have a 2-3 stock portfolio. But when you get above a 15-20 stock portfolio, you're pretty well as diversified as you're going to get in terms of spreading out the errors. And mistakes in valuation ought to be unsystematic errors.

If you do those three things, what you're left with is the macro risk. I think historically what value investors were prepared to do is say, "OK, macro changes are temporary changes. I can live with those. I'm not going to worry about them."

I think what we understand now is they can be very, very long-lived, both in terms of the unemployment, which is the real fluctuations, and in terms of what they can do to interest rates in trying to fight that. We've had five years of interest rates that nobody would have believed were possible.

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