Value Investing Principles Point to Success in Buying and Selling

The dilemma is we try to know something we can’t:

We know that to make money in the stock market we need to “buy low and sell high” which is easier said than done. Doesn’t that put us in the difficult position of trying to figure out if the market is going to go up or down? Even if we knew the market’s direction the next question is how low or high will it go so we can buy at the bottom or sell at the top?  The problem is we really don’t know the future although some like to pretend they do.

So does that mean our important investment decisions, centered on our hard earned money, must be rooted in guess work? The underlying problem is the vast majority of investors’ think of themselves as owning a piece of paper (stock certificate) whose price changes daily with the market and should be bought or sold around some economic or political event. Who can ever know all current or future economic or political events that might affect the markets? No one of course, so with that mindset, we will never know when to buy or sell. If we think like that we are just guessing.

The solution is to focus on what we do know:

The solution is in focusing on what we do know or can reasonably estimate, the underlying value of the company; the intrinsic value. When we change to this mindset and apply the tenets of value investing the answer becomes more apparent.

1. We are buying a business not a stock certificate. The stock certificate is an ownership interest in an actual business that has an underlying economic value independent of the share price on any given day.

2. Intrinsic value is the measure of the underlying economic value of the business. It can be estimated using different economic and financial measures, some better than others, regardless of what the stock price happens to be. Knowledge of the intrinsic value enables us to do our job in a disciplined manner. Without the intrinsic value we are speculating or gambling; not investing. Price is what we pay and value is what we get; intrinsic value shows us the difference.

3. The stock market is there to serve our interests. Among Benjamin Graham’s many insights is investors who try to follow the market are transforming their basic advantage into a basic disadvantage. He argues “…Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. By refusing to let Mr. Market be your master, you transform him into your servant”.

4. A margin of safety is needed to cover the potential errors we will make in estimating intrinsic value or unforeseen changes in the business. This discount is critical because it provides a margin for error to help us avoid permanent loss.

5. The one thing we don’t know is timing; how long it might take for the share price to catch up to the underlying intrinsic value. But we can rest assured it always eventually does. As much as we want to know the timing we don’t need to know timing to be reasonably successful while applying the tenets of value investing. Timing is taken out of the equation and our role is to be patient with a long term perspective and pleasantly surprised on occassion when things happen quickly.

Knowing the intrinsic value gives us an edge where we can rationally apply ideas from the Kelly Formula to help determine our position sizes.  The position’s size is a function of both its expected return and its anticipated range of outcomes. The math makes two simple but important points: (1) the larger the return, the bigger the position, and (2) the larger the range of outcomes, the smaller the position.

Buying a business should occur when valuation is compelling and the business’ prospects are most misunderstood causing the stock price to be depressed below the intrinsic value. A caveat is we have to periodically check assumptions that determine the intrinsic value estimate to either confirm or adjust.

Here’s one way, the way I use, to apply the tenets of value investing to buying and selling:

Rules for buying a business:

1. Buy when the estimate of intrinsic value identifies companies with a sufficient margin of safety. A potential core holding must show a 30% margin of safety and a special situation company (more opportunistic investment) must show at least a 50% margin of safety.

2. Buy when the business fundamentals indicate a favorable probability that intrinsic value will be recognized and achieved over the next 3-5 years.

3. Buy when there is an identified expected improvement in business conditions or a catalyst. The business likely experienced a setback, loss in investor confidence, or is ignored in the marketplace. Invest where a change is occurring in a key business segment, or where management or investor actions will act as a catalyst.

4. Concentrate capital into the best ideas where we believe potential risk is low and returns are high. Recognize that bigger stakes can be taken when information is adequate and outcomes are more certain. As Warren Buffett says; “Diversification is a protection against ignorance. It makes very little sense to those who know what they are doing.”

5. Consider each purchase as a potential 10% position eventually, start with relatively small positions by buying 1/3 the position at a time (2-3% of the portfolio) and increase or decrease as the investment thesis plays out, positions of up to 20 percent are permitted.

Rules for selling a business:

1. Sell about 1/3 the position at a time as the stock price approaches within 15% of the intrinsic value.

2. Sell on deterioration in the fundamental outlook such as a material adverse change in the business or return prospect. Negative events by themselves do not trigger the sale of a position but a reduction in the margin of safety or an event that prevents a reasonable estimate of intrinsic value will result in a sale.

3. Sell if the anticipated catalyst for change in business is significantly altered and the timing of the event is either delayed or eliminated, the investment will be removed from the portfolio.

4. Sell if a more favorable investment is found, based on opportunity cost considerations, the position will be liquidated and money moved into the new opportunity. The only exception is if the position is considered to be a long term core holding where compounded returns over time will likely far exceed the short term opportunity.

Treat cash as a byproduct of investing opportunities, not an objective.  A minimum of 5% is desirable to take advantage of opportunities that may occur at any time. In the absence of compelling investments hold cash and cash equivalents.

This cash strategy will not earn high returns every year, but helps avoid some of the potential permanent loss of capital more prevalent in short term strategies. Importantly it helps us earn higher cumulative returns over the longer term because the cash builds in higher markets and places us in an advantageous position to purchase in falling markets where we can buy companies sometimes far below intrinsic value.

Buy Sell Success

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