Stock Market Wisdom Debunked

Value investors are independent thinkers. They don't need the crowd to validate their ideas, nor do they act contrarian simply for the sake of being different. While Cisco (Nasdaq: CSCO  ) and Nortel (NYSE: NTL  ) were zooming up at the height of the tech bubble in the late 1990s, Warren Buffett was criticized as being out of touch with the realities of the new economy. Now that the bubble has popped, Buffett's company, Berkshire Hathaway (NYSE: BRK.A  ) , is close to all-time highs, while Cisco and Nortel investors have been slaughtered.

Buffett wasn't avoiding technology just to be a contrarian. Berkshire's portfolio has piles of great businesses bought at reasonable prices, not just cheap businesses bought when nobody else wanted them. Companies like Coca-Cola (NYSE: KO  ) and Gillette (NYSE: G  ) can hardly be considered cigar butts, but they've made Buffett wealthy nevertheless. Buffett's success can be attributed to well-reasoned purchases made within an investing framework based on value principles.

This approach sharply contrasts with most of the financial industry, which is why it is an interesting exercise to examine, from a value perspective, the popular wisdom that the financial industry pitches at investors every day.

"If you were out of the market for the best 30 days in the past decade, you would have lost money."
Mutual fund advisors often use this statistic to urge investors to stick with them for the long term, despite the fact that advisors themselves tend to be traders -- a managed mutual fund has an average turnover rate of 85%. But while being shocked and appalled at such hypocrisy is an entertaining hobby, it's also worthwhile to analyze the reasoning behind the claim.

The statistic is accurate: $10,000 invested in the S&P 500 a decade ago grew to almost $25,000 today (excluding dividends), while without the best 30 days, it would only be worth $7,700. But before making conclusions about market timing, consider the opposite statistic: If you were out of the market for the worst 30 days, you would have made $76,000. If the first statistic is saying that you should remain invested at all times, this statistic seems to be saying that trading to avoid bad days is critical. What gives?

Neither case is accurate. Rather, the statistic is used as propaganda to help fund companies pitch their funds and discourage investors from selling. There are many good reasons to be a long-term investor, including tax-free compounding, reduced expenses, and reduced risk. But this statistic is not a good reason.

What do these statistics mean to the individual investor? It's not clear, except that if you're a trader, some bad or good luck on a few select days could have very dramatic effects on your portfolio. But, as a value investor, they make me think of some potential benefits of a margin of safety. By buying a stock at a discount to its intrinsic value, I'm likely to avoid the worst of the fallout on those worst 30 days, and my long-term performance should be superior.

"The trend is your friend."
This catchy one-liner reflects the momentum that stocks gather: stocks going up tend to keep ascending, while stocks going down tend to keep falling. The logic driving the claim is a combination of psychology and faith. The psychology is that investors would prefer to buy a stock that's going up to therefore keep pushing it up. The faith is the belief that if something's going up, there must be some reason for it, so it will probably continue to do so.

This reasoning might work for day traders, but it is quite bizarre from a value perspective. First, if a stock is going up, then, all else being equal, it becomes less attractive to value investors because it is approaching -- or exceeding -- its intrinsic value. The upside is less and the downside is greater. Conversely, a stock going down becomes more attractive because both the margin of safety and potential return increase. Value investors love to buy goods when they're on sale. So the trend isn't a value investor's friend, but actually an enemy, like an evil maharaja, Jar Jar Binks, or a berserk koala.

The value investor's true friends are competitive advantages and a margin of safety. Competitive advantages ensure that the company will outperform others for a long time, while a margin of safety dramatically reduces the chance of the value investor suffering significant losses.

"Run your profits, cut your losses."
This expression is the bedfellow of the "friendly trend" from above (and with such a nickname, it has many bedfellows, including "buy high, sell higher" and "don't catch a falling knife"). It means that if you're making money on an investment, don't sell quickly, but if you're losing money, then run for the hills. Frequently, it's implemented with some sort of stop-loss rule, such as "sell any stock that falls by 10%." The idea holds some appeal, since if you have the same number of winners and losers, but make more on the winners, then you will come out ahead.

However, this reasoning trips over the same stumbling block as momentum investing: it ignores valuation. The fact that a stock has fallen 10% below your purchase price does not imply anything about the intrinsic value of the company. If the stock is down on negative news that decreases your estimate of intrinsic value, such as the recent news from Elan (NYSE: ELN  ) , then it may make sense to sell. But if the stock falls with no fundamental change, then a value investor would be more inclined to increase the position than decrease it, since the upside has become bigger and the downside smaller.

"The market is always right."
Traders say this when the market is not doing what they expect it to do. It generally means that the trader believes their reasoning to be incorrect, since the market isn't acting as planned. Consequently, they should cut their losses. I love this expression because it's so pessimistic. It reminds me of Eeyore, blue-grey donkey and portfolio manager: "I was just kind of guessing where the stock was going anyway, and was wrong. Oh well."

Value investors think this expression is quaint. The market is right occasionally, but overall it tends to be pretty bipolar, with individual stocks priced both above and below intrinsic value. Really, if a stock is priced at less than the discounted value of its expected future returns, then the market is wrong. In such cases, value investors are able to make extraordinary profits both from long-term growth in the business and from the stock returning to intrinsic value. In fact, identifying such stocks is Motley FoolInside Value's primary goal.

In conclusion
Many common investing expressions don't hold up when examined from a value perspective. However, this can be a great thing, as those who do believe in such maxims may push stocks away from intrinsic values, providing an opportunity for value investors to profit.

If you're looking for value investing ideas supported by sound independent reasoning, you might want to check out a free 30-day trial toInside Value. If you change your mind after signing up, we offer a prorated money-back guarantee. No hassles, no smallprint.

Richard Gibbons, a member of theInside Valueteam, was bitten by a berserk koala when he was 12. Richard owns Cisco call options, but none of the other securities mentioned in this article.

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