After reading numerous books and articles about value investing, you probably have realised that value investors love to reiterate the importance of having the right psychology and philosophy. It dictates our attitude towards learning and investing. Bearing in mind about how fickle-minded and manic the market is, we are a lot more conscious about how the market is feeling and what we should be doing.
However, value investors should take a step further beyond having a good grasp of the market psychology. Just because the market is overreacting, it does not mean that the securities affected are now undervalued. The fundamental value of the company does not change much, if at all, when prices fall. The true fundamental value should remain constant before and after the fall. The only thing that may change is our judgement of the value.
In this article, we will be sharing with you 2 characteristics of thinking you should adopt when you invest.
Before we begin, you must be aware that while value investing is a very broad umbrella term that covers all investing approaches with a reference value in mind, under this umbrella, there may be differing opinions and approaches. Our role is to guide and provide you with the resources and our personal insights for you to make your own value judgement and decide for yourself your preferred approach.
Second-level thinking by Howard Marks
The first major concept of this article called second-level thinking. This was introduced by a successful value investor, Howard Marks, in The Most Important Thing.
More than a trace of wisdom indeed. If you ever thought that by investing in all low P/E and P/BV “value” stocks will generate astronomical returns over the long run, you will be very disappointed to know that that is not the way to go.
Investing is simple but not easy. Investing, like economics, is more art than science. It requires you to make a judgement when things are ambiguous. What this suggests is that you should be thinking one step ahead and deeper than the crowd if you want to have any chance of beating the market.
A few examples raised in the book are:
- First-level thinking says, “It’s a good company; let’s buy the stock.” Second- level thinking says, “It’s a good company, but everyone thinks it’s a great company, resulting in the valuations of the company to be too high. So the stock’s overrated and overpriced; let’s sell.”
- First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic, resulting in the valuations of the companies to be oversold. Buy!”
- First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”
First-level thinking is shallow and groupthink while second-level thinking is complex and insightful. Second-level thinking seeks to excavate the fundamentals from the superficial observations.
The second-level thinker is clear about his or her guiding principles. Many aspects are considered before making any value judgement. Are you just following the crowd or are you sensitive of your own actions?
For your results to deviate from the norm, your approach and hence your portfolio, must deviate from the norm. You can’t follow the consensus. While there is an apparent “safety” in following the crowd, you can’t beat the market this way.
Source: The Most Important Thing
In order to achieve extraordinary profit, you have to be a contrarian, and be right.
How do you ensure that your judgement is the right one? We are never certain that we are making the right judgement but we are able to value-add our approach to account for the human errors we make.
Margin of Safety by Seth Klarman
There is a highly coveted book written by legendary value investor Seth Klarman called Margin of Safety. Basically, the idea behind this is that we should always be conservative in our judgement and discount the estimated value of the company to more than necessary to have sufficient buffer for any mistakes we will make.
In the book, Seth Klarman talked in great lengths about the psychology value investors should adopt and how important it is for us to be aware of the mistakes the crowd make daily.
Some nuggets of insights are as follows:
About having the right focus-
“The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.”
On adopting value investing-
“The value discipline seems simple enough but is apparently a difficult one for most investors to grasp or adhere to. As Buffett has often observed, value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned.”
“Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.”
Why Margin of Safety?
“It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”
When you first chance upon a company with an economic story that you really like, you immediately begin with your analysis. Chances are that you tend to forecast with optimism. Deep in your heart, you hope that this company has good economics, good value and makes a good investment.
These inherent biases are contrary to the philosophy of having a margin of safety.
Having a margin of safety, though, is not just solely about having a conservative estimate of value but also adopting the right focus and approach.
Do you find yourself always attempting to forecast the upside? Is the idea of risk foreign to you?
If these are true, you have to first relearn everything and focus on the right metrics before you even begin analysing your next potential investment. Starting off on the wrong foot will lead to derailment of your objectives.
Being aware of the mindset you should adopt is only the first of many steps to successful investing. While most know about the value investing approach and how it has reliably generated supernormal returns since the beginning of time, most refused to take heed.
Why? You may ask. It is all because of human psychology. People desire immediate gratification. The allure of “earning” $5,000 in a week from trading is much greater than following a slow-paced value-investing approach.
Our final word of advice: Listen to what works, not your instincts.