Welcome back for the final installment of my three-part series on the 10 commandments of value investing. If you are new to this series, you can click on the following links to read the first and second articles.
VIII. Invest for absolute, not relative, returns
One of the key philosophical differences between value investors and other market participants is the emphasis by value investors on absolute -- not relative -- returns. Here's an excerpt from Seth Klarman's Margin of Safety regarding the difference between investing for absolute returns and relative returns:
Most institutional and many individual investors have adopted a relative-performance orientation. They invest with a goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do.
Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way of the overall market or how other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For investors, absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.
Now, let me add my own two cents to this point. I believe that the financial media does a grave disservice by focusing on short-term relative performance. Most institutional money managers fear relative under-performance far more than they fear losing money.
I'm convinced that this continued focus on short-term relative performance is what caused so many mutual fund managers, even those who knew better, to buy Dell
While relative underperformance for a year or two is an unfortunate but very rational fear for professionals, no individual need fear short-term relative underperformance. Here again is an edge to the sophisticated individual willing to endure some relatively unexciting performance over shorter periods to ensure satisfactory long-term absolute performance.
IX. Watch the business, not the stock
Louis Lowenstein, the author of What's Wrong with Wall Street? wrote the following warning about stock prices:
Don't confuse real success of an investment with its mirror of success in the stock market. The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in business value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.
Value investing is the pursuit of purchasing a dollar's worth of business value for something less than a dollar. Because of the many promotional forces at work in the stock market (brokers, sell-side Wall Street analysts, CNBC, etc.) a stock generally has to be "out of favor" with the majority of stock market "voters" in order to fall to bargain prices. Maybe the industry is boring and out of favor. Maybe the stock is so small that it suffers from neglect by institutional buyers. Perhaps the company is suffering through temporary problems that are hurting its current numbers. Value investors get used to buying unloved companies.
Once purchased, value investors monitor the business to ensure that their estimate of intrinsic value is not flawed and that the business itself is not deteriorating. Just because the original purchase price was made at an attractive price doesn't mean that the stock can't go lower - this is why value investors are usually prepared to continue buying undervalued stocks as the price goes lower. Nobody can consistently time the bottom perfectly. Value investors must have the conviction provided by rigorous analysis that eventually the margin of safety built in to the price will protect them from true capital loss.
Many market participants, on the other hand, assume that if a stock goes up after they bought it that they were "right," while if it goes down, they must have been "wrong." Interestingly, the stock market is probably the only market in the world in which people become less interested in a purchase as the price drops. Of course, I don't mean to say that you should ever ignore the market altogether -- smart investing requires that one eye be kept on the stock price. Value investors look to sell their holdings when the stock market offers a price that represents full value or higher, and look to add to their investments when the market is offering a large enough discount. In the middle of these two ends of the spectrum, value investors are monitoring their interests as would any business owner.
X. Know when to sell
Value investors sell for four basic reasons. The first case is where the investor comes to the conclusion that the initial intrinsic value estimate is flawed. Value investing requires intellectual honesty, and errors must be acknowledged early. The second reason to sell is when another, even better value comes along that requires some capital to be freed up. The third case is when the business fundamentals upon which the initial purchase decision have deteriorated to the point where there is no margin of safety in the current price. The final reason to sell is when the stock price has moved up to a point to where the business is being fully valued and no longer offers a margin of safety.
My own selling philosophy is to sell a hefty portion of my investment at the middle of my fair value range, and as long as the business is performing well, to wait and try to sell the remainder towards the high end of fair value. Of course, I try to be very conservative about my estimate of fair value. Once the stock price has exceeded the fair value range, any continued holding constitutes a speculation that the stock will move higher and is not investing based upon true business value. Again, this is not necessarily bad, but one should be aware of the difference. Holding overvalued stocks with no margin of safety is a recipe for capital loss.
I'll leave you with these final thoughts. Buying businesses cheaply requires a willingness to go against the herd; selling businesses dearly requires parting with your investments when they are popular. You must learn to trust your own judgment rather than that of the market. Like many worthwhile pursuits, value investing is simple in theory, but hard in practice. Over time, however, the markets have rewarded those who have dedicated themselves to mastering the art of value investing.
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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.
