Imagine that you were standing on the podium at the 2006 Winter Games. To know that all of the hard work paid off with an Olympic gold medal dangling from your neck would be awesome.
While you and I may never be Olympic athletes, we do have the opportunity to make it to the top of the investing podium by beating the market. And in my opinion, value investing is the way to get there.
Michael Mauboussin, Warren Buffett, and Nassim Taleb are three great investment minds. Together, their three most important lessons lay the foundation for why value investing always takes the gold:
- Focus on decisions, not outcomes.
- Remember that price matters.
- Assess the odds correctly.
Decisions, not outcomes
I know you want your investments to generate great returns. I do, too. So we can't confuse luck with skill. According to Mauboussin, chief investment strategist at Legg Mason, if we focus only on the outcome of a decision rather than the process used to make it, we can be fooled.
It works in two ways. Just because we make a good decision doesn't mean our investment will gain in value. Conversely, just because an investment has gone up a great deal does not necessarily mean it was a good decision.
From the table below, you would think that Qwest was the good decision and Deckers the bad.
|
Buy |
Sell |
Return | |
|---|---|---|---|
|
Qwest (NYSE:Q) |
$1.62 |
$3.79 |
134% |
|
Buy |
Low |
Paper Loss | |
|
Deckers Outdoor (NASDAQ:DECK) |
$24.00 |
$16.92 |
-30% |
That just goes to show you that focusing on only the outcomes can be extremely deceptive. Although Qwest was more than a double for me, buying it was not a good decision. I was lucky rather than good, with no process behind making the decision. Luck is not something we can always count on.
On the other hand, did the 30% drop in Deckers' price right after I bought it mean my decision was a poor one? I would say no, because the process I used to come to the decision was better. I completed my due diligence and analyzed future growth prospects, which is much more of a supportive process than wishing for luck. However, despite a current price of $35.50, the jury is still out on whether the decision was truly a good one since the outcome is over a short period of time.
Price matters
That reminds me of Warren Buffett's quote: "Price is what you pay. Value is what you get."
We know Coca-Cola (NYSE:KO) and American Express (NYSE:AXP) are great companies. But just because they are great companies does not mean that they have always been great investments. Here is a comparison of their prices and multiples during the bubble and today.
| Aug. 1, 2000 Price | Aug. 1, 2000 P/E | Feb. 24, 2006 Price | Feb. 24, 2006 P/E | |
|---|---|---|---|---|
|
Coca-Cola |
$63.13 |
97 |
$42.23 |
21x |
| Oct. 2, 2000 Price | Oct. 2, 2000 P/E | Feb. 24, 2006 Price | Feb. 24, 2006 P/E | |
|---|---|---|---|---|
| American Express |
$63.00 |
32 |
$54.87 |
21x |
I think you'll agree with me that Coke and American Express were expensive during the bubble, especially since their earnings are even higher today. So despite the fact that they still had the great brands and distribution networks and management teams even then, they were not great investment opportunities during the bubble. So you can see that it's important to find great businesses, but to make sure that you're buying in at a price that will add value to your portfolio.
Assessing the odds correctly
In chapter 6, "Skewness and Asymmetry," of his book Fooled by Randomness, Nassim Taleb shows why investors need to assess the odds and bet accordingly.
Analysts expect Hansen Natural (NASDAQ:HANS) to grow earnings at 20% for the next five years. So, to justify its $2 billion market cap, Hansen will have to earn returns greater than its cost of capital for 17 years, assuming a 12% cost of capital.
Admittedly, the company has some very strong brands. But given the success of energy drinks, I expect the competition to really heat up over the next three to five years. In fact, companies such as PepsiCo (NYSE:PEP) have already stepped up their efforts to go after the profits in this new and expanding area.
So here's the question: Despite the company's fantastic performance and the popularity of the stock, are you willing to bet that the company's competitive position is strong enough to fend off competition from Pepsi and other behemoths for 17 years? And if it can, is the expected payoff from today's price high enough to justify the risk?
To me, the odds seem asymmetrical with the future success built into today's stock price. If the company does not meet expectations, the price will decline with revised expectations. And if the company does meet expectations, the stock price is unlikely to increase significantly. As such, that's not a bet I would be willing to take.
A gold medal investing standard
At the Fool's Inside Value newsletter, Philip Durell and his team use these three core principles to evaluate the universe of stocks and make recommendations. Omnicare (NYSE:OCR) is a perfect example of how Philip uses these three tenets. Omnicare performed very well as a business and as a stock, but Philip had concerns about its price relative to its value. As such, he assessed the odds and determined that the right decision was to make a sell recommendation. So far, that decision has paid off. But Philip also understands that only time will tell.
If you're ready to win the gold as a value investor, come be our guest at Inside Value free for 30 days. With full access to the site, you can see what it's like to stand up on the podium with Philip.
Fool David Meier owns shares of Deckers Outdoor but does not own shares in any of the other companies mentioned. Coca-Cola is an Inside Value recommendation. Deckers Outdoor is a Motley Fool Hidden Gems recommendation. The Motley Fool has adisclosure policy.
