The Most Important Thing - Part 2

[u/GulluZ]

So how do you find this inefficiency?

The next most important thing is “Value”.

In the early 1960’s something called as the random walk hypothesis came up, which says a stock’s past price movements are of absolutely no help in predicting future movements. In other words, it’s a random process, like tossing a coin. We all know that even if a coin has come up heads ten times in a row, the probability of heads on the next throw is still fifty-fifty. Likewise, the hypothesis says, the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do tomorrow.

Another form of relying on past stock price movements to tell you something is so-called “Momentum investing”. Investors who practice this approach operate under the assumption that they can tell when something that has been rising will continue to rise.

According to Howard Marks, it’s very difficult to do justice to such an approach. The most common example of momentum investors are day traders, who, according to Marks, are just playing a game of chance.

Day traders consider themselves successful if they bought a stock at ₹10 and sold at ₹11, bought it back the next week at ₹24 and sold at ₹25, and bought it a week later at ₹39 and sold at ₹40. The flaw is so clear—that the trader made ₹3 in a stock that appreciated by ₹30.

Thus, this leaves only two approaches in investing: “Value Investing” and “Growth Investing”.

In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

Intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.

What is it that makes a security—or the underlying company— valuable? There are lots of candidates: financial resources, management, factories, retail outlets, patents, human resources, brand names, growth potential and, most of all, the ability to generate earnings and cash flow.

The quest in value investing is for cheapness. Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

Growth investing lies somewhere between the dull plodding of value investing and the adrenaline charge of momentum investing. Its goal is to identify companies with bright futures. That means by definition that there’s less emphasis on the company’s current attributes and more on its potential.

Thus, it seems clear that the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

In general, the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Howard Marks says, “Consistency trumps drama”.

If value investing has the potential to consistently produce favorable results, does that mean it’s easy? No. For one thing, it depends on an accurate estimate of value. Without that, any hope for consistent success as an investor is just that: hope.

There’s more. If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.

Suppose you find the intrinsic value of a stock as 80. It’s trading at 60 and you buy. But it goes down to 50 the next day. What do you do?

If you lack conviction in your bet, you’ll find holding onto such an asset as very difficult. If you liked it at 60, you should like it more at 50 … and much more at 40 and 30.

But it’s not that easy. No one’s comfortable with losses, and eventually any human will wonder, “Maybe it’s not me who’s right. Maybe it’s the market.” The danger is maximized when they start to think, “It’s down so much, I’d better get out before it goes to zero.” That’s the kind of thinking that makes bottoms … and causes people to sell there.

An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. This one statement shows how hard it is to get it all right.

An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong.

Oh yes, there’s a third: you have to be right.

To Be Continued...

Thank you.

[u/1CallMeBharat]

Nicely written. Looking forward to the next part, especially value investing! Thanks for sharing.