When Warren Buffett speaks, I listen. During the Berkshire Hathaway (NYSE:BRKA) annual meeting, Buffett said the keys to being a successful investor are temperament and the right basic idea.
Buffett also said that "all intelligent investing is value investing." So if you want to be an intelligent investor, then you need to know the required temperament and the right basic idea. Instead of just telling you what I think they are, I'll pose some questions to bring the concepts to life. Your job is to go through them, write down your answers, and compare them to the ideas that I believe Warren preaches and that Philip Durell, lead analyst for the Motley Fool Inside Value newsletter, practices.
Temperament
If you plan to buy stocks over the next five years, do you want prices to rise or fall?
When should you buy stock in a company?
Over time, what is your job as a value investor?
The right basic idea
What do great value investors do?
What is a value investor's No. 1 rule?
What is a value investor's secret weapon?
Do you have your answers? (No peeking! Don't go on until you have your answers.)
OK. Here are my thoughts:
If you plan to buy stocks over the next five years, do you want prices to rise or fall?
If you plan to buy stocks over the next five years, you want prices to go down.
It's hard to resist buying stocks when prices are going up. But you must. The sales machine that is Wall Street loves it when stock prices go up because it can use all kinds of techniques to force you into action. "You're going to miss out if you don't get it now." "It's already gone up 100%, and it's got plenty of room to soar." Have you thought about buying Travelzoo (NASDAQ:TZOO) because it keeps going up and up and you don't want to miss out? Well, you shouldn't. When prices rise, you are more likely to take on additional risk, especially when prices rise above a fair estimate of the value of a company.
When should you buy stock in a company?
Clearly, you want to buy when prices are low. But there's more to it. You want to buy when the expected value of an investment is positive.
Michael Mauboussin, now chief investment strategist at Legg Mason, wrote "The Babe Ruth Effect" to explain why investors must think in terms of expected value, which is the probability of occurrence times the magnitude of the outcome.
Is it more likely that a stock price will go up or go down? That is probability of occurrence. The tough part is determining how much it will go up or go down. Here's how it might look for a value stock.
| Probability | x | Magnitude | = | Expected Value | |
|---|---|---|---|---|---|
| Loss | 70% |
-5% | -3.5% | ||
| Gain | 30% | 20% | 6.0% |
Even though this value stock is more likely to go down, its expected value is positive and makes it an investment worth considering.
One of Philip's Inside Value recommendations is First Data Corporation (NYSE:FDC). Since joining the list in December 2004, First Data's price has fallen slightly. Would Philip like to see "green" on the scorecard for First Data? You bet. Would he mind a drop in price? No. And neither should you. Assuming that Philip's understanding of the company is good (and I believe it is), a falling price will decrease the magnitude of loss and increase the magnitude of gain. Thus, the expected value goes up, along with your chances of getting three tens for a twenty.
Over time, what is your job as a value investor?
You want to understand how to assess expected values. And the best way to do that is to stay humble, recognize what you don't know, and go learn it.
Overconfidence can kill. You can make any investment look good by overweighing the positive and underweighing the negative. Your investing success depends on being able to be vaguely right rather than precisely wrong.
You need to study business fundamentals and analyze financial statements. You need to know your own decision-making tendencies and you need to learn how the stock market works. Fortunately, the Fool's School has all kinds of great resources, including discussion boards to exchange thoughts and ideas.
What do great value investors do?
They purchase investments for less than they are worth.
That's all they do. They look at an opportunity, make an estimate of how much it is worth, and determine how much they are willing to pay for it. Investors such as Warren Buffett, Bill Miller, Wally Weitz, and Motley Fool Senior Analyst Bill Mann invest this way in order to put the odds in their favor, knowing full well that not every choice is going to be a big winner. Some will be big winners, but odds are, none of them will be big losers.
Sirius Satellite Radio (NASDAQ:SIRI) recently acquired the rights to broadcast NASCAR events. Talk about content that is sure to bring in new subscribers! NASCAR fans are probably more loyal than Howard Stern fans. But will it bring the 20 million more subscribers needed to justify its market value? If not, how much more content will Sirius have to buy to reach the scale required to break even? I am not going to speak for the investors above, but I don't think today's stock market is less than what Sirius is worth. To me, the bet is not in my favor.
What is a value investor's No. 1 rule?
Never lose money.
While this sounds a bit trite, it is very important for two reasons. First, it takes more returns to break even.
|
Loss | Gain to Break Even |
|---|---|
|
-10% | 11% |
|
-25% |
33% |
|
-50% | 100% |
| -90% | 900% |
Second, negative returns kill the power of compounding.
| Year | 1 |
2 |
3 | 4 |
5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| Yearly Return |
10% | 20% | -20% | 30% | 15% | -10% | 20% | 10% | -10% | 5% |
|
Cumulative Return | 10% | 32% | 6% | 37% | 58% | 42% | 71% | 88% | 69% | 77% |
| Average Returns | 6.5% | |||||||||
| Yearly Return | 10% | 20% | -10% | 30% | 15% | -5% | 20% | 10% | -5% | 5% |
| Cumulative Return | 10% | 32% | 19% | 54% | 78% | 69% | 102% | 123% | 112% | 122% |
| Average Returns | 9.3% | |||||||||
| Performance increase | 2.8% |
From the example above, cutting your losses in half enables you to keep the compounding engine running more efficiently, generating better returns. Always make investment decisions with this rule in mind.
What is a value investor's secret weapon?
It's those three magical words: margin of safety, defined as the difference between your estimate of intrinsic value and the stock market price.
Engineers don't build bridges close to a material's ultimate strength. A change in load or a small error in an analytical model can cause the bridge to collapse. So why should you pay stock market prices close to a company's intrinsic value?
As investors, we do not have perfect information, and the market is not a stable working environment. Most important, our analytical tools are nowhere near as powerful as physics-based models. The margin of safety is necessary to protect us from ourselves. But it also juices up returns by reducing the downside while increasing the upside. Said another way, the higher the margin of safety, the higher the expected value, and the more the odds are in your favor.
In my personal portfolio, independent power producer AES (NYSE:AES) is by far my strongest performer. It also had the highest margin of safety at the time of purchase. So, as you can see, I use it. Philip uses it. The great ones use it. You should, too. It will take you to investing nirvana.
How'd you do?
If you didn't do as well as you hoped, there's no need to worry. The Motley Fool and Inside Value can help get you on the right path.
If your answers matched half of the questions, you are well on your way to being an intelligent investor, and Inside Value can help reinforce what you know and provide additional insights and ideas to help you continue to move forward.
If you did well and this was merely a review, you get it! For you, Inside Value can help with great ideas and encouragement to stay the course.
Research shows that value investing outperforms the market. To see how Philip Durell is beating the market, try Inside Value risk-free for 30 days.
Fool contributor David Meier owns shares in AES but not in any of the other companies mentioned. The Motley Fool has a disclosure policy.
