Buy When The Black Swan Flies; Sell When It Comes Home To Roost

by: David J. Waldron

Summary

Value investors on Main Street buy wonderful companies with strong fundamentals when macroeconomic events produce attractive valuations.

Then sell or reduce the holding on weakened fundamentals or inflated valuations when microeconomic events erode the company's financial strength or the demand for its products and services.

But Mr. Market continues to entertain the purchase of attractive fundamentals at otherwise high prices and narrow margins of safety.

Thus, the Value Investing for Main Street Model Portfolio [VIMS] is currently more a watch list than a buy list.

Welcome to the second installment of the Value Investing for Main Street series.

There is an age-old adage in value investing that dictates the purchase of wonderful companies with strong fundamentals via stocks or funds when macroeconomic events occur and the sale of the same companies or funds when microeconomic events weaken the fundamentals. In other words, buy on the indirectly unrelated macro event and sell on the directly related micro event.

Two powerhouses of investing wisdom, essayist, Nassim Nicholas Taleb, and value investor, Warren Buffett, have each succinctly defined the macro and microeconomic impacts of intelligent investing.

Black Swan Click to enlarge

The Black Swan

In his bestselling nonfiction book, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007), Mr. Taleb presents his black swan theory, or the extreme impact from certain kinds of rare and unpredictable events or outliers. He then explores the human tendency to find simplistic explanations for the occurrence in retrospect. This rationalization is in spite of taking a beating as a result of the surprise episode.

From an investment perspective, the timing of the book was profound as the Black Swan event that became known as the sub-prime mortgage crisis that led to the Great Recession occurred one year after Taleb's book was published.

But Mr. Taleb writes that he does not attempt to predict Black Swan events. To the contrary, he proposes that being aptly prepared for these surprise macro events, should one occur, is more prudent than actually predicting them. He illustrates by suggesting a Black Swan event is a "surprise for the turkey but not the butcher." An obvious translation of his theory is the typical Wall Street philosophy of trying to predict market fluctuations, i.e., the market timer as the turkey, versus manipulating the market's ebb and flow to your advantage after they unexpectedly occur, i.e., the value investor as the butcher.

Attempting to Predict Black Swan Events is a Fool's Game

If the Wall Street market timer is wrong in predicting a Black Swan event, granted incorrectness is often the more likely outcome, he or she will lose substantial assets from being too long or too short. On the other side of the trade, the main street value investor is already prepared to take advantage of any surprise Black Swan macroeconomic event by allocating planned cash reserves to take new or increased positions in the stocks or funds of fundamentally strong companies. He or she takes advantage of indiscriminately depressed prices from the macro event. These incidents, any tragedies notwithstanding, are the main street value investor's white swan.

For example, investors on Main Street and Wall Street that held, added, or initiated quality positions immediately following the Market Crash of 1987, the Dot Com Crash of 2000-2002, and the Great Recession of 2007-08 invariably profited from subsequent booming portfolios. Yes, a few did luckily predict these events and perhaps benefited even more, but many investors reacted after the fact by foolishly selling-off already depressed securities. And more than a few of these Black Swan victimized portfolios have yet to recover.

I have observed that investors who successfully predict a Black Swan event often become intoxicated by the lucky call and begin to base his or her investing philosophy on the sudden perceived ability to predict future events. Such inebriation of financial intellect induces the proverbial crystal ball that encompasses a false state of being. The luck soon runs out as does the principal on his or her investments.

Close the Doors and Become Rich

Fear and Greed are Pricing Mechanisms for Value Investors

The value investment theory of buy when the Black Swan flies, a surprise event affecting an entire economy or sector; and sell when the swan comes home to roost, a surprise event affecting only a company or industry is also presented as a metaphor by Mr. Buffett:

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. - Warren Buffett

What Mr. Taleb wrote so eloquently in a 400-page book, Mr. Buffett independently coined in a brief passage. The lessons of Taleb and Buffett for main street value investors are to stop market timing or stock trading and start investing or divesting as macro and micro economic conditions dictate.

Fundamentals, Valuation, Margin of Safety... and a Watchlist

The current Wall Street consensus appears an overheated bull market where speculation rules and valuations are mostly ignored. Shorts are perhaps the present exception although engaging in speculative activity, nonetheless. But the value investor on Main Street sticks to the tried and true approach of researching a company's fundamentals for ownership or divestiture; then measures its valuation metrics to determine whether to buy, add to, reduce, or sell the holding.

As a result of the present climate, the Value Investing for Main Street Model Portfolio [VIMS] is coming together more as a watchlist than a buy list. In future articles, we will seek out wonderful, fundamentally strong publicly-traded companies or funds of companies that we would love to take part as proud owners. We are advocates of those companies' quality products or services, and consistent profitability. When warranted, we add the stocks or funds to the VIMS Model Portfolio's watchlist.

We will remain steadfastly patient as we await Mr. Taleb's unpredictable Black Swan macroeconomic event, or Mr. Buffett's fearful Wall Street retreat from stocks. As prices drop to attractive valuations, we will sift the VIMS Model Portfolio watchlist for superb, fundamentally sound companies trading at appealing valuations that offer what we perceive as reasonable margins of safety. At that point, and only at that juncture, will we add the corresponding large, medium, and small cap stocks, non-leveraged ETFs, and open-ended mutual funds to the realtime VIMS Model Portfolio.

And whenever the swan comes home to roost, or Wall Street traders get greedy, thereby negatively affecting the fundamentals, valuation, or margin of safety of a single holding, we will consider reducing or eliminating our ownership in that position. Conversely, if the micro event or trader-induced fears render attractive valuations with perceived wide margins of safety, we will purchase a new stake or add to the position.

For the sake of consistency, the VIMS Model Portfolio is given a K.I.S.S. in all we do while managing it, i.e., Keep Investing Super Simple.

The Value Investing for Main Street Mission Statement

Investment Objective: Buy and hold dividend paying, well managed, financially sound businesses, or funds of companies, that produce easy to understand products or services, have enduring competitive advantages from wide moats, enjoy steady free cash flow, and are trading at a discount to our estimate of intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.

We are Choreographing a Portfolio, not a Ballet

Click to enlarge

Bulls and Bears Attending the Ballet

We never celebrate Black Swans and the inevitable damage each does to fellow dancers in a ballet, or, in our arena, to the victimized inhabitants of an affected economy or sector. But we revisit our portfolio and watchlists and commence new research to look for individual companies or funds of companies where strong fundamentals, attractive valuations, and comfortable margins of safety merge in a rare perfect storm of opportunity. It is our inherent responsibility as value investors of Main Street to be greedy when Wall Street is fearful.

And when Wall Street is greedy, or the swan comes home to roost in an invested company or industry, we reverse course and reduce or sell-off as key metrics dictate. We accomplish this with large doses of rationale saving any emotion to celebrate successes or assess failures after the fact, but never before.

The Value Investing for Main Street Series on Seeking Alpha

I was humbly excited by the number of new followers from the inaugural series article, Introducing: Value Investing for Main Street. If you have gotten this far in the second installment, I encourage you to click and read, or reread, the initial article for continuity.

I also invite readers to "follow" me by clicking the orange button below to receive alerts for the subsequent build-up of the Value Investing for Main Street Model Portfolio presented exclusively on Seeking Alpha. Comments are strongly encouraged and always welcomed. Then join me, one primary ticker at a time, in literally seeking alpha with limited capital, lower costs, and less risk than the titans of Wall Street.

The Main Street Value Investor's Creed

I will leave you with another enduring dose of investor wisdom from Warren Buffett that we hold as the main street value investor's creed:

The 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

-Warren Buffet, from his 2013 letter to Berkshire Hathaway (NYSE:BRK.B) shareholders.

Thank you for reading the Value Investing for Main Street series on Seeking Alpha. Please read the important accompanying disclosures.

Copyright ©2016 by David J. Waldron, LLC. All rights reserved.

Value Investing for Main Street and the VIMS Model Portfolio are trademarks of David J. Waldron, LLC.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are not intended for portfolio construction beyond the contributor's model portfolio which is solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. This article is neither intended as investment advice or as a recommendation to buy/hold/sell/short or avoid any securities. Readers should always engage in further research and consider (if appropriate) consulting a fee-only certified financial planner, discount licensed broker/dealer, flat fee registered investment adviser, reputable attorney, or certified public accountant before making any investment, income tax, or estate planning decisions.