Walter Schloss, a legendary value investor, shared with us about the key guiding principles that have led to his success. In the previous article, Schloss shared with us 3 crucial mistakes value investors should never ever make.
To summarize the first article, the crucial mistakes that you should never make are:
- Don’t buy on tips for a quick move
- Don’t let your emotions affect your judgement
- Don’t be in too much of a hurry to sell
The underlying guiding principle to avoid the above three grave mistakes simply is that you must have an investment philosophy to keep you on track. Knowing your weaknesses and how susceptible you are to external influence is the first step to becoming a successful value investor.
Now, you are ready to dig deeper and uncover Schloss’s secrets to outstanding returns!
Getting the first thing right from the start
1. Price is the most important factor to use in relation to value
Company ABC has once again beat the analysts’ estimates and share price rallied by 20%! Growth prospect is tremendous and everyone seemed to be convinced that this company is definitely the future.
Sounds really familiar? Of course it does! When the market is optimistic, there are plenty of such companies around. You should be able to name a few off the top of your head.
Investors, retail and institutional alike, get excited at the thought of 30-40% compounded annual growth.
However, trees do not grow to the sky.
The business case for the company may be seemingly impeccable but as a value investor, or any investor for that matter, you should be very concerned about the price that you are purchasing at. No matter how amazing a company is, there is always a right price to buy at and a right price to sell at.
The obsession over such “hot” companies are driven by greed rather than any fundamental grounds. When the smoke clears and weaknesses of the market exposed, those whose capital is locked in the company will be in trepidation.
2. Establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper
Your perception towards what holding a share means to you matters a lot. If you view a share as a lottery ticket that may potentially bring you wealth in the future, you are perhaps better off going to a casino. There are tons of traps laid down by professionals all over the financial market to capitalize on retail investors’ folly.
By putting the same amount of effort as if the company is yours (it is yours!), you will not only be an expert in the company over time, you will learn more about the characteristics that are prevalent in turnaround companies. This knowledge is no doubt extremely pivotal in value investing.
3. Use book value as a starting point to try and establish the value of the enterprise.
Book value is the claims of owners on the business. The statement of financial position is split into assets and claims. Assets of the business and claims against the business. Claims can be further classified into liabilities and equity.
When you invest in a company that goes bankrupt, the company will attempt to liquidate all its assets and pay off its liabilities (bondholders) first. Whatever residual value of the company that is left goes into the ordinary shareholders’ pocket.
Book value, when adjusted conservatively, provides a good indication of the value of the company. Value is defined in different ways by value investors. However, the approaches should never deviate from the idea of having certainty. If you see a value investor forecasting 50% revenue growth per annum with a discount rate of 7%, his or her portfolio is probably not doing really well.
4. Be aware of what you are doing and feeling
Very often, a lot of very bright and hardworking investors spend a huge proportion of their lives researching and analyzing in preparation for the next big opportunity. But chances are, many still fail to perform even if they understand the crux of what value investing is.
Have you ever heard of students who are smart but “blanks out” during exams and end up doing badly? Emotions play an extremely huge part in our decision making. Under immense stress, emotions may take over and make decisions that we will only regret after.
Schloss is aware of such psychological influences and has a few things to share with us.
5. Have patience. Stocks don’t go up immediately
There is a natural tendency for investors to have the desire for prices to rally immediately especially if you just started out investing and are eager to apply your knowledge.
This impatience is extremely harmful to your portfolio. A disciplined value investor is able to brave through fluctuations of the stock prices before it reverts back to its intrinsic value.
6. Be a contrarian investor and be right. Don’t be influenced by the crowd
There is a very good reason why more than 70% of active managers fail to outperform the index. The finance industry is structured around benchmarks and standards that pull fund managers together to behave in the same manner.
Standards such as tracking error, implicitly condemn the fund manager if it deviates too much from the index. Beta, as a measure of risk, is supposed to reflect if the fund manager is taking too much risk unnecessarily.
Chasing such indicators will mislead and distract investors from making the right decisions.
7. Have the courage of your convictions once you have made a decision
Be consistent while adaptable. You have to know the distinction between being consistent and stubborn.
Let’s say, you have a mental model of your investment philosophy in your mind. By being courageous of your convictions is to execute this plan out regardless of any external noise. At the same time, you will constantly review and learn from your mistakes.
8. Have a philosophy that works for you and follow it
This is possibly the most important step before you even begin investing. Only after you have a grounded strategy, will you be able to invest with courage and direction! By following the value investing way, you will have a good night sleep even when the market plunges and everyone freaks out.
9. Buy discounted assets rather than earnings. Earnings are unpredictable while assets change slowly
The discounted cash flow (DCF) method is an extremely popular method of valuing a company. Theoretically, it is a very sound concept. Since we generally prefer $1 now than to receive the same $1 5 years later, we should be able to discount the $1 5 years later to a present value.
However, this method is most of the time too uncertain for a value investor to utilize effectively. There are multiple assumptions to be made that are subject to biases and random factors.
While using present earnings is less uncertain than cash flow, earnings are subject to accounting manipulations. By using assets to value, as suggested by Schloss, you can adjust the value of each asset as conservatively as possible, giving you a larger margin of safety.
10. Listen to suggestions from people you respect
Bearing in mind that people you respect are humans prone to making errors too, you don’t have to take in everything your role model says. But keeping an open mind and having the attitude to learn will develop you as a person and an investor. This growth mindset is a very important motivator especially when things seem to go awry.
Final word of advice
We have learnt a lot from great investors like Walter Schloss and we believe that it is due to this innate passion for discovering more about value investing as a way of life that has shaped our way of thinking.
Unlike many other branches of investing, there is no set approach to how to invest under value investing. We don’t just blindly pick stocks with low price to book value and hope for the best. If it were that simple, value investors won’t be able to generate such outstanding returns since the beginning of time. Cultivating the right psychology and mindset is still the most important overall.