As investors head into the new year, there are many questions regarding what returns they should expect after a stellar 2013. Before searching for any investment opportunities, I believe it is important to review the tenets of sound investing, which I provide in this article. Many of these points originated from famous investors such as Ben Graham, Warren Buffett, Howard Marks, and Seth Klarman.
This article is not about my outlook or stock picks for next year. Rather, I want to provide readers with some fundamental principles or points to keep in mind as they formulate their investment plans for 2014. While it is ultimately the profitable investment ideas that generate great returns, these points below will help investors find profitable ideas and avoid dangers when they search for investing opportunities in 2014. I agree with Warren Buffett that having the right attitude and principle is more important than having a great understanding of the technicals (i.e. accounting, finance and economics).
Point #1: Valuations Matters, Momentum Less So
"In the short term, the market behaves like a voting machine, but in the long term it acts like a weighing machine"
After a 30% rally in the S&P500 (NYSEARCA:SPY) this year, investors may start to forget that a stock represents an ownership of a business and not a ticker that jumps around every day from 9:30am-4:00pm. Momentum was the name of the game in 2013 as the biggest winners in 2013 were momentum stocks like Tesla (NASDAQ:TSLA) and Netflix (NASDAQ:NFLX). However, focusing solely on momentum is dangerous because the market is a weighing machine in the long run as Graham observed.
The biggest problem with momentum investing is that it works until it doesn't. A large run-up in stock prices is inevitably followed by a rapid decline. Some investors argue that they can ride the upside and can escape early enough to avoid the downside. Nonetheless, it is a daring adventure I believe many investors should avoid. If great profits can be obtained by buying stocks that did well in the past, then the Forbes's billionaire list should consists of only librarians as suggested by Buffett. As these momentum stocks move higher and higher, it may be more difficult to find a greater fool who is willing to pay a higher price for these stocks.
Focusing on valuations is the fundamental principle of investing. Investors must have a view of what the intrinsic value of the stock or bond they are buying and only buy when the current price is significantly below the calculated intrinsic value. Many investors often ignore valuations because it is intangible and very subjective. However, history has shown that the overvaluations and undervaluation will be corrected. The timing may be unknown but mean reversion is an important concept to remember for investors. Purchasing an undervalued stock or bond will also limit risks. The low price results in higher expected returns for the investment which is often more than enough compensate investors for the risks they take. Using a coin analogy, if you purchase an undervalued investment it's either heads I win or tails I don't lose too much.
I believe everyone can be more intelligent regarding their security purchases if they just ignore the fact there is an active market place. Buy stocks similar to how you purchase every-day goods like groceries. The fact these every-day goods doesn't have an active marketplace to immediately sell them after force the purchasers to exercise prudence regarding the value of the goods. As Warren Buffett famously said, "If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes". Although investors should have an investment horizon less than 10-years, they should at least have an investment horizon of 2-3 years. Wall Street and many "experts" only have an investment horizon of 1 year or less. Hence, having a longer investment horizon will increase your own odds of winning.
Point #2: Stay Within Your Circle of Competence
"I don't look to jump over 7 foot bars, I look around for 1 foot bars that I can step over"
The circle of competence is a concept pioneered by Buffett which states that investors should practice investment strategies and buy securities that they are most comfortable with. Many will be misled by the constant noise of other investors and financial commentators regarding "hot stocks" or "latest buys". Even for conservative investors, hearing the huge success some had trading Twitter's (NYSE:TWTR) stock can be a powerful motivator to abandon their own strategy. However, if investors have a sound strategy, they should not abandon it just because other strategies appear to work better than their own. An index fund investor would be foolish to abandon their portfolio and start buying hot stocks like Twitter or Tesla. It can be very tempting to do so because of peer pressure and the feeling of being left out. Avoiding negative influences is hard but essential to sound investing, which should be as boring as watching paint dry. Follow Warren Buffett's advice of looking for 1 foot bars you can step over. If you have a sound investing strategy or plan, make sure you actually it.
Table 1 lists some of the investing fads during the last century and most people got sucked into buying them because they wanted to avoid being a maverick.
Table 1: Lists of Investing Fads that Ended Badly
|1970s||Nifty Fifty Stocks|
|Late 1980s||Junk Bonds|
|Late 1990s||Internet Stocks|
|Mid-2000s||Structural Finance Products + Lots of Leverage|
Point #3: Exercise Shrewd Judgment When Going Against the Herd
"I've put it this way: just because no one else will jump in front of a Mack truck barreling down the highway, doesn't mean that you should"
A common advice by successful investors is to go against the herd or practice contrarianism. However, Greenblatt reminds investors that don't just go against the herd for the sake of going against the herd. While it is true that the herd can be very wrong at times, it doesn't mean the herd is wrong all the time. One must have a strong thesis and solid evidence for against the herd. In my opinion, there is a clear difference between good contrarianism and bad contrarianism as shown by the two bullet points below:
- Good Contrarianism= Thorough Analysis + Humility + Patience
- Bad Contrarianism = Inadequate Analysis + Ignorance + Impatience
Good contrarianism requires a thorough analysis of why the herd is wrong and why going against the herd makes sense. Also, good contrarianism requires humility and patience. On the other hand, investors practicing bad contrarianism conduct limited analysis and think they are smarter than everyone else so they must be correct. Bad contrarianism is usually a recipe for disaster but the results are less evident because those who practice bad contrarianism usually hide their past. Therefore, the wonderful results for going against the herd has a survivorship bias. Going against the herd can be just as dangerous as following the herd if the investor does not exercise prudence.
Point #4: Manage Risk Prudently
"The most important thing is understanding risk, recognizing risk and controlling risk"
In his book titled The Most Important Thing, the Chairman of Oaktree Capital listed 20 most important things for investors. Three items on his lists focused on risk management: understand, recognize and control risk.
Investors should realize that risk is not measured in terms of betas or standard deviations. Risk is the possibility of a permanent loss of your capital. Therefore, investors should evaluate all the factors that may lead to a permanent loss of capital. This steps allows investors to understand all the possible risks. It is not enough to list a worst case scenario because usually the worst case is not worst enough and it is insufficient to identify only one bad scenario. All the scenario should be considered. Given all investments are risky, investors must demand a sufficient risk premium for holding the asset. For example, equity investors should buy when the earnings yield is sufficient to justify the purchase. In fixed income, credit spreads should be sufficient given the credit risks taken. Therefore investors can control their own risk by taking on risks only when the risk premium is adequate and the amount of risk taken is reasonable per unit of expected return.
Point #5: Focus on "Intelligent Investing"
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return"
There is no better sentence that describe intelligent investing than the one Ben Graham wrote in Security Analysis in 1934. What is thorough analysis? In my opinion it is about having a clear idea of intrinsic value (point #1) and evaluate all the necessary risks involved (point #4). The investment also must promise an adequate returning, meaning your expected return should be enough to compensate you for the risk you take. Intelligent investing is that simple, however Charlie Munger kindly reminds investors that investing "isn't supposed to be easy".
Another aspect I believe is important for intelligent investing is the differentiation between first level and second level thinking as espoused by Howard Marks. He made this point clear in his book by illustrating the following example:
First-level thinking says, "I think the company's earnings will fall; sell". Second-level thinking says, "I think the company's earnings will fall less than expected, and the pleasant surprise will lift the stock; buy"
How does the concept apply to today's investing environment? I will give the following example:
First-level thinking says, "the Fed is tapering QE and bond yields should rise; sell fixed income instruments". Second-level thinking says, "Tapering may push yields higher but that won't impact all fixed income instruments equally. Fixed income pricing comes from two components (1) interest rates levels (2) credit spreads. Tapering of QE means the economy is improving so credit spreads should tighten; there is still opportunity to buy certain investment grade or high yield bonds"
As Marks said in his book, "first-level thinking is simplistic and superficial", while "second-level thinking is deep, complex and convoluted". Investors wishing to invest intelligently should keep Graham and Mark's words in mind when they look for opportunities in 2014.
The 5 points above is very important when evaluating investing opportunities. Forgetting these basics can be very dangerous especially today's market environment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.