This article has been adapted from our sister site across the pond, Fool U.K.
James Montier, one of my favorite investors whom I've profiled for our "Investment Greats" series, has recently published a white paper titled The Seven Immutable Laws of Investing. As the name implies, the paper addresses what he sees as the seven truths or principles that should guide sensible investors. Let's review.
1. Always insist on a margin of safety
Montier devotes most of his paper to this very important point. He describes valuation as the closest thing to the law of gravity that we have in finance, as well as the primary determinant of long-term returns. We must aim to buy below our estimate of fair value, giving ourselves a margin of safety in case of errors or misfortunes.
Worryingly, he does not see any asset class as offering a margin of safety at current prices (or more accurately, at the prices in March), in absolute terms -- true, some are relatively cheaper than others, but that is not an endorsement. It's like being presented with the two ugly sisters and being forced to date one of them. Montier would rather hold cash and wait for Cinderella to come along.
2. This time is never different
The more things change, the more they stay the same; it's easy to forget that sometimes and to think that we are working with a new paradigm, especially one in which prices continue to rise far above their long-term trend lines.
And "long term" is the key -- Montier makes the point that looking at the 30 years up to 2007, one might conclude that house prices had never fallen in the United States, but taking a longer time period or a more international perspective, there was plenty of evidence to suggest that a sharp correction was due.
Rather than throwing out the handbook of investment, we may be better advised to stay true to the principles that have guided sensible investments since time immemorial.
3. Be patient and wait for the fat pitch
In words often attributed to Warren Buffett, "The stock market is a wonderfully efficient mechanism for transferring wealth from the impatient to the patient."
Montier makes the point that far too much emphasis is placed on annual, monthly, or even daily performance, when really we should be focusing on the longer term. We should also be on our guard against "action bias" -- the desire to do something. This is arguably easier for private investors, who don't have the same requirement to appear busy.
Instead we should wait for the "fat pitch," the ball that we really should play, rather than playing every ball that comes our way regardless of quality.
4. Be contrarian
John Maynard Keynes said that "the central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive."
It sounds easy when stated like that, but to go against the herd is to go against human nature, to the extent that it can almost physically hurt.
"Being a contrarian is a little bit like having your arm broken on a regular basis," Montier says, but "I can't believe that valuation-indifferent speculation will end in anything but tears."
5. Risk is the permanent loss of capital, never a number
Using beta as a proxy for risk may be mathematically elegant, but risk is not volatility. Quoting Keynes again: "It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them."
We should regard risk as the probability of a permanent loss of capital, and that loss can come from three sources:
- Valuation risk -- paying too much for an asset.
- Fundamental risk -- underlying problems with the asset that you're buying. Also known as value traps.
- Financing risk -- leverage.
6. Be leery of leverage
"Leverage is a dangerous beast," Montier says. "It can't ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn't transform it into a good idea."
Much of what is termed "financial innovation" is nothing more than thinly veiled leverage, and he believes we should view it with skepticism.
7. Never invest in something you don't understand
This is a mantra you'll see repeated very often on The Motley Fool, and Montier agrees with it: "The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself."
In his opinion, if you can't understand it, you shouldn't be investing in it.
To what extent will these seven "immutable laws" inform your decision-making? Let us know in the comments section below.
More from Padraig O'Hannelly: