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The business of value investing – Six essential elements to buying companies like Warren Buffett- Charlie Tian 2009
https://bbs.pinggu.org/thread-695143-1-1.html (Page 200-207)
Pessimism Leads to Value
Avoid That Which Is Most Valuable
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A value-oriented investment approach in the style of Graham and Buffett is not designed for bull markets. If our stock market were always bullish, there would be no need for a value investing approach. Unfortunately, markets can’t go up forever, so value investing- the act of purchasing assets or securities for less than what they are worth- focuses on markets characterized by declining prices and valuations. During bull markets, a lot of people are mistaken for investment geniuses when in fact it’s the rising tide that’s moving them up in the world. Bear markets, however, distinguish the intelligent investor from the fly-by- night speculator. In his 1961 letter to partners, a 31-year-old investor in Omaha named Warren Buffett said that they should be judging him during times of turmoil and not times of jubilance. “I would consider a year in which we declined 15% and the [Dow Jones Industrial] Average 30%, to be much superior to a year when both we and the Average advanced 20%.” Very early on in his career, Buffett was aware that performing well during market turmoil was the key to long-term success as an investor. During the 13 years that Buffett ran his partnership, not only did his performance destroy the Dow Jones Average during both bull and bear markets, but he also never had a down year. While other investors have come along and produced records that outshine Buffett’s, Buffett’s preservation of capital has allowed him to compound money at a staggering rate. It should come as no surprise that the most fertile hunting ground for picking up good companies cheap is during the height of bear markets, when fear and uncertainty run rampant. Fear is an emotion. When investors are making decisions based on emotion, such decisions are very likely to be irrational. Numerous psychological studies have demonstrated that humans feel the pain of loss much more acutely than the pleasure of gain. Merely sitting on losses, even ones that have not yet been realized, is too painful for many. The instant reaction when it comes to stocks is simply to sell off the loser so the “loss” is no longer visible. Successful investors understand this erratic behavior and seek to exploit it. Back in 1973, after nearly two decades of stock price appreciation, the markets fell hard. Most people fled the equity markets, thus missing out on one of the century’s best buying opportunities. A similar situation occurred from late 2002 into 2003, after the tech bubble: Dirty laundry was washed out and securities were cheap again, but everyone was afraid- even though the gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals, buying when they should be selling and vice versa. One of the worst days in the stock market just happened to be one of the best buying opportunities in the stock market. Value investors thrive when markets are consumed with fear. A fearful market environment leads to an inefficient market. When markets are inefficient, the discrepancy between market value and true value is as wide as ever. Instead of finding 50- or 60- cent dollars, you begin to see 20- or 30-cent dollars. And therein lies the real value brought about during periods of market pessimism: Owning stocks actually becomes a less risky proposition. Very few people find comfort in distressed markets, and owning stocks is seen as being more speculative. This viewpoint only confirms the backwardness with which many investors continue to pursue investing. The question that has yet to be answered is “How is it that buying a dollar’s worth of assets for 75 cents is comforting, yet when that same dollar of assets is now selling for 35 cents, the investment is regarded as carrying more risk?” The answer, of course, is that it is not. Unfortunately, when investors rush for the exits during bear markets only to return upon the arrival of good news, they have chosen to forgo the 35- cent purchase and wait to buy when the price hits 75. Regarded as arguably the greatest stock picker of the twentieth century, John Templeton, brilliantly remarked, “The four most dangerous words in investing are ‘This time it’s different’ ”Euphoric markets always seem to have a way of fooling many investors into thinking stock prices will always go up. Such nonsensical beliefs are the number - one reason why many investors make poor investment choices that lead to permanent losses of capital. Templeton is widely known for making investments during periods of extreme pessimism. In 1939, after World War II broke out in Europe, Templeton borrowed 10,000 and he used that money to buy 100 shares each in 104 companies that were selling at 1 dollar per share or less, including 34 others that were in bankruptcy. In the end, Templeton reaped large profits on 100 of the companies while the remaining 4 turned out to be worthless. Fifteen years later, in 1954, Templeton launched the Templeton Growth Fund. From 1954 to 1992, the flagship fund delivered a 14.5% annual rate of return; a 10,000 dollar investment, assuming all dividends were reinvested, would have been worth 2 million. All great investors always have had the courage to make significant investments in a business during maximum points of pessimism.
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Warren Buffett did just that with American Express in the 1960s when the company was suffering from the salad oil scandal, a major corporate scandal in 1963 that involved American Express extending millions in loans to Allied Crude Vegetable Oil backed by Allied’s salad oil inventory. When it was discovered that the collateral was containers of water and not oil, American Express shares declined over 50 percent as a result. With many investing luminaries exhibiting similar traits in their investing activities, it’s worthwhile to go deeper into their approach to see why it pays to invest during the direst of situations. Examining these activities by understanding the opposite approach- investing in businesses at the maximum point of optimism- offers great value. Since the market punishes the stock prices of those businesses to which it assigns maximum pessimism, then it would make sense that the most highly valued business in the world are the ones that the market views with maximum optimism. Rephrasing Buffett, odds are very high that you are paying full value or a premium price to invest in the popular issues of the day. It would seem crystal clear to us all that anytime an asset is bought in an environment characterized by many buyers, the price paid will not be as attractive as when the same asset is bought in the presence of few buyers. The economic laws of supply and demand apply to the markets. When demand is high for securities- during bull markets- prices increase to satisfy that demand. Conversely, when there is very little demand for equities- the consequence of bear markets- prices decline. Auction houses are proof positive of this theory. By attracting more bidders, auction houses are attempting to extract the best possible price they can. Many distressed assets are sold via auction in an attempt to maximize the price attained for the asset. Realizing this, value investors understand that the best possible time to buy securities is when very few buyers are present. The absence of demand creates a very high probability of purchasing assets for substantially less than replacement cost or intrinsic value. By investing in a business during the rosiest of times, investors almost guarantee that the price paid will be at a premium to the underlying intrinsic value, thus creating an investment without any meaningful margin of safety. As a result, investors place their capital at greater risk for loss should the business suffer a slight mishap. During bull markets, this investment approach will surely be confused with an intelligent approach, as a rising tide lifts all boats. Then again, if all we had were bull markets, a value investing approach would not be needed, since all the attributes of investing- exercising due diligence, investing with a margin of safety, looking for companies with excellent economics and honest and able management- are for the purpose of weathering the bear market storms and emerging with your capital intact.
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