Ooh-bi-doo, I wanna be like you
I wanna walk like you, talk like you, too
You see it’s true, an ape like me
Can learn to be human too.
Song from the film of The Jungle Book (1967)
If you were wandering through the jungle and ran into a tiger the chances are you’d panic and climb the nearest tree. We’re all subject to powerful emotions such as fear because underneath it all we’re nothing more than monkeys. But when it comes to investing, allowing strong emotions to influence you will kill returns. If you understand the risks then you can learn to control your inner monkey. The resulting discipline is sure to bring you bigger profits.
Everyone knows you’re supposed to “buy low, sell high”. A simple enough dictum, but hard for most people to execute in practice. But the good news is that you don’t have to be “most people”, just so long as you know how not to be.
In fact, by definition, it’s practically impossible to “buy low, sell high” for most people for a simple enough reason. Prices collapse, are low, or stay low because there is little interest in buying that asset at that time. For whatever reason whole asset classes go out of fashion from time to time. That means few people are looking to “buy low”.
At the same time, if prices are in the stratosphere it means investor interest is extremely high, and people will pay practically anything to get their hands on the latest hot thing. Mob mentality takes over. Instead of selling high they are buying.
Emotions are powerful influencers of our actions. But that doesn’t mean we can’t try to do better by understanding what we’re being subjected to.
So in practice most investors end up buying high and selling low. And they do that because they are acting like monkeys. This is not to criticise most investors (or to denigrate monkeys). Emotions are powerful influencers of our actions. But that doesn’t mean we can’t try to do better by understanding what we’re being subjected to.
If the stock market has been rising strongly for the past year then chances are its progress will be plastered all over the newspapers and television. Excitement builds, people do interviews explaining how rich they’ve become, investors become elated at their (paper) gains and buy more, and others jump on the bandwagon for fear of missing out.
At the other extreme if there’s a stock market crash then most people panic. Financial news outlets turn the drama setting up to 11 and emotions run high. People get out of the market at low levels, believing that the financial world is about to end.
To prevent getting swept up in this kind of self-destructive activity you first need to understand the drivers. Then you need to use the higher functions of your logical human brain to override the lower functions of your emotional monkey brain.
In finance lingo it’s about being “contrarian”, which means doing the opposite of the crowd. To do that you need to focus on underlying long term values and not on short term market price swings.
This is what value investing is all about, and it’s what we encourage here at OfWealth. In finance lingo it’s about being “contrarian”, which means doing the opposite of the crowd. To do that you need to focus on underlying long term values and not on short term market price swings.
Let me explain that further. Something’s “value” is what it’s actually worth. This is a subjective measure which requires knowledge and experience to work out. There are lots of fancy financial formulae that can be used, but also some relatively simple methods. The main thing is to use assumptions that are conservative, such as how much a company’s earnings will grow in future. Value is something you work out using your logical human brain.
Price is something different, and shouldn’t be confused with value. Price is a specific, observable amount that you can pay to buy or receive to sell an investment, such as a share. It’s set by market supply and demand, and is the level where, at the margin, some investors are currently persuaded to sell their holdings or to buy more.
Prices are set by the investing mob’s monkey brains, and stocks and shares are their bananas. When the mob is hungry for bananas they’ll do anything to get them. When they think someone has poisoned the bananas they will leave them to rot on the tree.
Share prices jump around all day, every day, whenever the market is open to trade them. Sometimes they can move suddenly higher or lower by large amounts, even if the earnings prospects of the underlying company are little changed.
On the other hand, the underlying values of the shares are relatively stable, even if they’re fuzzier to measure. Over time most companies grow their earnings and net assets. In some years they grow a little more, and in other years a little less. But the usual trend is steadily upwards over time.
This is why stock markets always rise over the very long run, even if there are sometimes several years, even decades, when they don’t. But somewhere in the world there is always a cheap market offering the prospect of tasty future profits.
The key to value investing is to buy when something’s estimated value is substantially above current market price.
The key to value investing is to buy when something’s estimated value is substantially above current market price. This upside to fair value is called the “margin of safety”. So if you think a share is worth $15 but you can buy it for $10 then your margin of safety is 50%.
You don’t know when, but you expect that one day others will realise the share is cheap and bid it up to fair value, or even well above that level. So you buy it cheaply, and patiently wait for that to happen.
In the meantime the value itself is usually increasing, and you’re probably receiving dividend income as well. I usually reckon this process of reaching fair value takes two to five years. However it can take longer sometimes, and very occasionally it takes much less time.
So in my example let’s assume it take 5 years for the P/E to move from 10 to 15. That’s a 50% total gain, or 8.4% a year with compounding (profits on profits). Earnings per share (EPS) grow say 5% a year, which means fair value also goes up 5% a year (assuming fair value P/E is unchanged). And let’s say I get a 3% cash dividend paid to me as well, which is fairly typical for a value investment.
That means I’d make 16.4% a year compound return, before taxes (8.4% plus 5% plus 3%), assuming no reinvestment of dividends to buy more shares. With dividend reinvestment into more shares each year the return would be slightly higher, as there would be extra profit compounding.
But what if I’d bought the original investment with a P/E already up at fair value 15, and hence with no margin of safety? My return would be reduced to 8% a year (EPS growth plus dividend yield) if the price stayed at fair value. That’s still not bad, but you can see how buying the share cheaply in the first place adds a big additional source of capital gains. That’s value investing.
…despite temporary setbacks, established companies will usually solve their problems within a year or two and value will be restored.
Of course businesses sometimes go bad and value is genuinely and permanently destroyed. But most of the time, despite temporary setbacks, established companies will usually solve their problems within a year or two and value will be restored. In fact, when great companies have temporary problems it can be a great time to buy into them, when everyone else is giving them the cold shoulder.
Most investors make the mistake of focusing on prices all the time, even checking their portfolio several times in a day. This exposes the investor to their inner monkey.
As market excitement builds in a booming market, and prices rise, the investor’s elation makes them want to jump on the bandwagon and buy more overpriced shares. When the market crashes then fear kicks in and they sell positions for a realised loss. This monkey business ensures that they underperform the market in the long run. It’s what happens when investors allow themselves to succumb to greed and fear.
The key to being a successful private investor is to focus on value and rarely check prices. Let’s say you buy into a stock index fund when it has a P/E of 10, which is most likely well below average and so a bargain. (The median P/E since 1871 of the S&P 500 index in the US is just under 15. Currently it’s trading well above that, at a distinctly rich level touching 20.)
You don’t need to look at the price more than a few times in the year. If it gets to a level where it starts looking expensive, say a P/E of 17 or 18, and if there are better bargains elsewhere, you may sell and switch your funds over. And if there is a stock market crash, which will be blasted over the news, instead of selling out you should wait for the dust to settle and buy more of the index fund at a bargain price.
Even a relatively inexperienced private investor, with little training, can use fairly simple rules of thumb to guide them in working out whether something is a bargain or not.
At the whole stock market level I’d suggest investing or divesting stock index funds along the following broad lines (levels for individual stocks are more complex, depending on things like their business sector):
- Buy heavily if the P/E is less than 10
- Buy lightly if the P/E is less than 14
- Hold (don’t buy or sell) if the P/E is between 14 and 17
- Sell, or reduce positions, if the P/E is above 17
These are not hard and fast rules. They’re just broad guidelines (if you want to find out more about the P/E see here.). And you must remain diversified at all times, whatever the relationship between prices and values. But using these kinds of guidelines you can then concentrate on finding the cheap markets to buy into, or which of your existing investments to sell.
There is no reliable measure I’ve ever seen for timing when markets will rise or fall. Many people make confident predictions, but they are usually wrong. But we can always compare market prices with underlying values and decide if we’re getting a relative bargain or not. Whatever the short term price swings, bargains will usually work out well in the end.
If you follow a disciplined approach that overrides emotions, fellow OfWealthers, you stand a much higher chance of investment success. The first step is to learn to control your inner monkey.
Stay tuned OfWealthers,