Tuesday, February 19, 2013

Ten Principles of Value Investing

"Buying a Dollar for 50 cents". I love the idea, but find it rather difficult to do in real life. Offering such a trade to someone resembles nothing more than an offense and trying to make a living of such an activity would probably put you at the limit of legality.

In the investing world however, a group of people are dedicating their lives at doing only that; they do not buy assets unless they are offered for significantly less than their fair price. Those Value Investors, as they are known, have produced inspiring examples of investment success like Benjamin Graham, Warren Buffett and Seth Klarman, to name but a few.

These legendary investors often adhere to a strict discipline in their approach (even if the Oracle of Omaha seemed to have taken a sidestep with Heinz recently); and having guidelines surely helps as value investing is not a quiet journey. 

In today's post, my colleague Michael Wassermann is sharing the top 10 principles he is following in order to be consistent in this difficult art. Michael has been financial analyst and strategy consultant prior to entering the world of Private Banking three years ago. I like his approach and discussing with him always spurs further thinking on my side. He was kind enough to write this piece summarizing the way he approaches stock investing.

This blog entry is the first in what I hope is going to be a rich "Be My Guest" series where writers other than me will contribute and share their views. This will hopefully help in making this blog diverse in opinions and topics explored.

I am still working on "Hunting for European Smaller Companies- Part II". What Michael exposes here will certainly help in screening for stocks.

Enjoy the read and see you around soon,


My Ten Principles of Value Investing

By guest writer Michael Wassermann

Investing can take different shapes and forms. Let me share some thoughts on an investment style that works for me – Value Investing.

Rather than dwelling on definitions of Value Investing, here are 10 principles that I follow, inspired by legendary investors (Graham, Buffett, Klarman etc.).

1. Never invest without a Margin of Safety. Investing involves a lot of uncertainty. To account for human mistakes, complexity, and bad luck, securities should always be purchased at prices sufficiently below intrinsic value (at least 30% discount compared to a conservative company valuation; see here for fundamental valuation techniques). Such a Margin of Safety is best achieved by buying securities that are "Safe and Cheap".

2. Do your own homework. Unfortunately, successful investing requires a lot of homework, including research and analysis. You can look at what other investors you respect do as a source of inspiration – copying is okay in investing – but you'll only have the confidence required to take sound decisions (and stick to them) if you do your own analysis. If you don't want to invest the time and effort, best would be to delegate your investments to professional managers.

3. Be contrarian. The most lucrative investing opportunities can often be found in out of favour, boring, odd, small, disappointing stocks (for instance, stocks trading at multi-year lows). If everybody loves a stock, it is likely to be quite expensive. As a contrarian investor, I prefer for instance Apple at $450 than at $700.

4. Be flexible. To capture value opportunities, you need to be flexible, agile and unconstrained. This is the great advantage of the small private investor over large institutions – use it. The only relevant constraint should be: avoid what you don't understand, put it in the "too hard" pile.

5. Be patient. Good things happen to cheap stocks – but the timing is unpredictable. Patience is critical to deal with the (inevitable) curse of being too early, and to be able to "wait for the fat pitch". I like to keep a substantial amount of cash as dry powder to be used when extraordinary opportunities arise (they often do eventually).

6. Buy and sell. This is possibly somewhat controversial (many value investors adopt a buy-and-hold approach) and could be perceived as contradictory to the "Be patient" principle. However, whilst I believe that you should always invest with a long-term perspective in mind, I also like to take advantage of market movements to buy more of stocks that have sold off, and trim positions that have appreciated.

7. Make volatility your friend. Too many investors are afraid of stock price volatility and assimilate volatility to risk. From my perspective, risk is the permanent loss of capital, not a number nor a Greek symbol. Volatility creates opportunities and as such is the value investor's friend.

8. Beware of debt. A rock solid balance sheet takes part of the financial risk of investing away. As a rule of thumb, I try to avoid non-financial companies with a debt to equity ratio above 1.

9. Don't over-diversify. You want to focus on your best ideas rather than overly diversify your portfolio. Buffett is right again: "Diversification is protection against ignorance".

10. Be disciplined. Investing is a highly emotional activity. Maintaining a disciplined approach (for example, by using a checklist) helps avoiding many traps like spending too much time on macro noise, getting seduced by the latest fads, falling in love with a stock, and panicking.

Further reading. The value investing literature is very rich and contains a wealth of wisdom. Below is a selection of 3 timeless generalist books that I find insightful and that I often re-read. For updated intelligence, I also highlight the investor letters of 3 investing gurus.

3 books:
The Intelligent Investor, by Benjamin Graham.
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, by Seth Klarman.
The Little Book of Behavioral Investing: How Not To Be Your Own Worst Enemy, by James Montier.

3 investor letters:
Warren Buffet's Berkshire Hathaway shareholder letters: http://www.berkshirehathaway.com/letters/letters.html

Howard Marks' Oaktree memo's: http://www.oaktreecapital.com/memo.aspx

Jeremy Grantham's GMO quarterly letters: http://www.gmo.com

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