Abstract
- Risk is an illusive concept. However, the author tries to outline how one might perceive risk by highlighting the three ‘dangers’ that may lead to a permanent loss of capital: valuation risk, business/earnings risk and balance sheet/financial risk.
- Loss aversion, herding, availability and excessive confidence are but some of the behavioural stumbling blocks that hinder value investors to do what we “know to be right”.
- When do you stop researching and start acting on an investment idea? The author advises: “It is a common misunderstanding that in order to make good decisions we need masses of information. However, nothing could be further from the truth.”
James Montier has written a comprehensive book that explores all nooks and corners of the value investing philosophy. Here’s some of the highlights!
The Trinity of Risk
As you may recall from Against the Gods, risk is a most illusive concept. In chapter 11 of Value Investing James tries to make it more concrete by presenting the Trinity of Risk. James starts off the discussion by proclaiming that “risk remains finance’s most misunderstood concept. Risk isn’t a number, it is a concept or a notion.” (p. 105) He agrees with basically all other value investors that risk isn’t volatility; risk is the danger of permanent loss of capital. There are three interrelated of such dangers:
- Valuation Risk: Buying an asset at too high a price diminishes your margin of safety. To acquire assets that are highly reliant upon good news and always exceeding analysts and investors’ expectations is bound to result in drawbacks sooner or later. Hence, the advice is as the same as given so often here on the blog: calculate a conservative estimate of intrinsic value, and only strike when the asset is offered at a substantial discount to said value.
- Business/Earnings Risk: What are the odds that the quality and earnings power of the business in question may deteriorate? That’s the main question one has to ask when assessing this domain of risk. However, all businesses go through ups and downs, so surely a poor period or unfortunate news can’t be avoided. In cases as such investors need to “assess whether changes in earnings power are temporary or permanent. The former are, of course, opportunities, the latter are value traps.” (p. 105)
- Balance Sheet/Financial Risk: When considering a company’s balance sheet, you don’t necessarily need a P/BV below 1 for it to be ‘safe’. A business may be considered a low-risk investment based on the two former domains, and as you know, some businesses are worth paying a premium to book value for (see Damn Right!, The Essays of Warren Buffett and Charlie Munger: The Complete Investor). However, if the i.e. P/BV is unusually high combined with a low current ratio, you should probably tread carefully. As James states: “The purpose of balance sheet analysis is to detect the presence of financial weakness that may detract from the investment merit of an issue.” (p. 106)
As touched upon, it’s probably unrealistic to believe that you’ll be able to find a great company with little business/earnings risk selling at a low valuation in terms of i.e. a DCF-valuation as well as a low P/BV. It’s the ‘sum’ of all considerations that should guide you when evaluating the level of risk in a particular idea.
Behavioural Stumbling Blocks to Value Investing
Chapter 14 explores the stumbling blocks that hinders value investors to do what we “know to be right”. James mentions loss aversion, herding, availability and excessive confidence.
These are probably all familiar demons to most readers. Loss aversion; the pain of seeing your portfolio’s value shrink may cause you to sell at the worst of times. It may also lead you to take profits too readily in the fear of loosing the profits you’ve already earned. The fear of loss may too even hinder you from entering an attractive investment idea! In this instance Jeremy Grantham says: “If stocks are attractive and you don’t buy and they run away, you don’t just look like an idiot, you are an idiot.”
If you sell in order to “run with the crowd” you may be in double-trouble. In The Most Important Thing Howard Marks taught us that “the wisdom of crows” is a paradox, since the ‘truths’ that seem obvious to everyone are not usually so truth after all. Hence, if you sell a value position to chase a glamour stock, you may have taken the downfall on the former just in time for the drawback on the latter. Now that would be a true travesty. On p. 136, James highlist a quote from John Templeton that seems appropriate to this discussion: “To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.”
As we learned in Irrational Exuberance, excessive confidence may come from a belief that you’re smarter than the market when running with the crowd. One may knowingly enter an obvious glamour – or bubble – stock because one believes he or she is smarter than everyone else and thus able to exit before it bursts. That’s a bold and risky strategy indeed.
In short, be aware of these stumbling blocks and do your best to overcome them. One way of doing so is to follow James’ “Ten Tenets” in chapter 15. It’s a list of traits and advice that aid the investor in his quest for profits. I have presented many such lists before in i.e. Charlie Munger: The Complete Investor, Warren Buffett Speaks and The Value Investor’s Mindset, so I’ll merely leave you guys with a recommendation to check out the chapter.
Keep it Simple
An issue I have everytime I analyse an investment idea is when to stop researching and start acting. “What have I missed? What risk factors haven’t I considered? Why is the stock undervalued? Is it even?” are but a few of the questions analysts may ask themselves – I sure do.
If it sounds familiar you may seek comfort in James’ opinion: “It is a common misunderstanding that in order to make good decisions we need masses of information. However, nothing could be further from the truth. […] Too much time is spent trying to find out more and more about less and less, until we know everything about nothing. Rarely, if ever, do we stop and ask what we actually need to know.” (p. 195)
James advises his readers to find out what’s important and focus on that rather than “collecting endless amounts of information.”
To round-up this book summary I think this final quote captures the essence of long-term value investing. Though I have tremendous fun analyzing stocks and learning about the investment universe, the actual discipline of investing should be boring, as so neatly put by Paul Samuelson: “Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow.” (p. 138)