Investors are drowned in bullish propaganda when reading CNBC, The Wall Street Journal, and Seeking Alpha articles boosting their thoughts on the S&P 500 (NYSEARCA:SPY) settling in another all-time high. For the most part I ignore it. Financial advisors, financial planners, investment managers, and individual investors all have some interest in understanding the concepts of value investing. Taken as a whole, predicting where the markets will go in the future is a fool's game and price targets are often worthless. Since 2009, the market has appreciated greatly and those who have invested heavily the past few years have benefited as well. There are still several pitfalls investors must watch out for to prevent making mistakes and potentially big ones losing a lot of capital. Value investing isn't followed by everyone nor will it ever be in part because you either pick it up right away or never understand it. For those who do and are interested in value investing philosophies and thought process, below is a guide through the thinking of a value investor when the markets are at all-time highs.
Key to Investing
Investing is the intertwined fabric of economics and psychology. Human behavior and interaction affects every aspect of business and the results of business decisions. It is no surprise then it affects investment results profoundly especially when one considers two huge motivators: the fear of losing money and the greed of making more. One of the first steps to becoming a great investor is to learn accounting. Warren Buffett was recently on CNBC by phone encouraging a Make-A-Wish student to take every accounting course he could find and read up on it. Over the years it has paid off for me and I was self-taught and still learning. It's the language of business and first step in understanding how to value a business. Once you learn accounting it is imperative to practice and shoot for ambitious goals like reading 500 pages of financial reports, 10-Ks, 10-Qs, industry information, etc. every week. A lengthy and studious process, but one that will pay of dearly in the future.
Once one has a grasp of accounting, then they can begin the process of valuing a business. Value investing is a bottom up approach that requires one to be within their area of competence to understand the full impact of industry dynamics, competitors, and specific accounting measures. One great way to lose money is to invest in a business or industry in which an investor has very little insight or knowledge of. Reading and learning new information continually often preludes good luck and fantastic opportunities. With a little foresight in a particular industry or business where the market doesn't yet see, there is potential for outsized returns if proven correct.
Valuations both Qualitative and Quantitative
The main valuation technique used by value investors is using a discounted cash flow model. The first step is calculating owner earnings:
Net income + Depreciation + Amortization - Share-Based compensation - Capital Expenditures = Owner's Earnings
Often times analysts will exclude share based compensation and capital expenditures from calculations to make their models support current and future share prices. Needless to say this is frothy and inaccurate reflections of actual business conditions. Capital expenditures required to maintain the competitive moat should be subtracted and usually requires a little guessing by the investor what the true figure is. Share-based compensation should be subtracted because it not only dilutes existing shareholders, but is a real expense and depending on type of stock options used, can be very costly.
Then you predict and run earnings out 5 to 10 years in the future, the better competence and insight one has will pay dividends here. The earning estimates should be variable and have up and down years to reflect actual business conditions. The earnings past 10 years into infinity is often referred to the terminal value. Both the terminal value and first 5 or 10 year of earnings in the future should be discounted back to present value. The discount rate used is a very important part of valuing a business.
The problem with using a discount rate is that an investor is likely to adjust it to match current stock prices and market valuations to justify their research. An investor has to be prudent to either ignore stock prices in totality or realize that the stock price has affected their own valuations to a certain extent. Additionally, one must factor in how honest and able management is. Reading the past 5 years of annual reports and measuring their successes and failures, shareholder letters, and business strategies will give an investor a huge insight into how talented management is. It will also help an investor weed out inconsistent managers and management teams prone to making bad decisions after bad decisions, the virtues of being a bad business.
Another important factor affecting the discount rate is interest rates. The higher the interest rates, the higher the discount rate should be. Increased interest rates bring down the value of all assets because they increase the monetary value of holding cash. A few important considerations to take into account for the discount rate to be used are how strong the business moat is against new and established competition, how shareholder friendly management is, and leaving oneself with a margin of safety. This not only reduces risks, but also increases the probabilities of higher returns.
Once you have a range or idea of what the business is worth, now you have to decide if it is worth buying. Investing is arrogance at its best. If one is buying a security, you are basically saying the seller is wrong and their reasons for selling are incorrect. The opposite is true as well. This creates a fabric of human judgment and behavior that can vastly affect share prices in certain instances. Earnings and return on capital are what drive stock prices over time. If the outlook by the market for that particular company is gloomy, despite current high earnings and past growth, they will sport a low P/E ratio. Does this mean they are cheap or cheap for a reason? The key for any value investor is to find out why a company is undervalued or why the market is valuing it the way it is. Only after finding out the answer, can one truly begin to decide if an opportunity is presented. If it is undervalued for good reasons, then one can move on and keep looking. However, if one discovers that the fear is overblown or to be just a temporary problem, then one may have found a great opportunity. Because opportunities are scarce, when one is presented a shrewd investor buys all they can with conviction and courage.
Selling is often the hardest part of investing. As Warren Buffett has mentioned before, he prefers to buy companies that he never has to sell. This doesn't fit well with mainstream investors or Wall Street due to their reluctant need for activity and satisfaction of doing something.
Holding a few well run businesses with strong economic moats and management that is honest and shareholder friendly will generate very satisfactory results for individual investors and institutional investors. However, when a fundamental change has occurred or new facts warrant action to sell, one must do so and act rather than thinking they will be okay.
It is also okay to sell shares to buy shares in another company that one believes to present an even better opportunity. Value investors apparently do not believe in diversification because it requires too much time to look over a huge portfolio and great ideas do not come about that often. I guess I am in the minority who believes in patience over diversification because patience proves to provide better returns over the long haul than diversification.
Read, Read, Read!
Investors will do themselves well if they read Poor Charles Almanac a compilation of speeches and writings by Charlie Munger compiled by Peter D. Kaufman, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William N. Thorndike and Influence: The Psychology of Persuasion by Robert B. Cialdini. Their ideas and wisdom spread far beyond investing and economics; however, they will provide a framework for astute investors to earn highly satisfactory returns.
Understanding the psychology of human behavior, business models, and various interactions at flow in the investment world is a huge undertaking. The benefits and values an investor can gain from such a vast skill set opens the door to many opportunities in the future. Hard work, due diligence, and some good luck is what separates an above average investor from an average or mediocre at best. And yes, I do not believe in any academic theory like the modern portfolio theory.
S&P 500 at 2000
One may be wondering why no in-depth discussion of the S&P 500 being above 2000 for the first time in history was provided yet. There is only limited advice needed when investing in a broad index fund that many investors choose to invest in their 401(k)s. If an investor has been investing over the past several years, he or she is probably not looking to be buying but actually selling and holding short term securities and cash awaiting better opportunities. If an investor just got a new job or looking to invest spare cash at these levels, then he has a couple of options. He can wait a year for lower levels or use dollar cost averaging. I suggest investing well over 15% their paycheck into the S&P 500. Investing all of one's capital in the S&P 500 near a record high at one time is not a sound strategy. Sadly this does occur when people hand their money over to financial advisors who know no better.
Investors who wait a year or sell for cash and prove to be wrong because the market keeps going higher can always get back in the market with dollar cost averaging. Although requiring prudence and discipline, an investor taking this route will be satisfied knowing they made an intelligent mistake rather than an irrational decision in times of distress. Fearfully selling or buying greedily without controlling ones emotions and fears will lead to big mistakes. Being patient, diligent, and opportunistic will prevent big mistakes and open the door to better opportunities. I cannot repeat this enough, if you are to do well in investing you must avoid big mistakes.
Value investing starts by determining why a business is believed to be undervalued or valued the way it is. Once one has the answer to this question, then they can begin deciding if an opportunity is present or not. A lot of second-level thinking, reading, and knowledge goes into making a decision whether to buy or not to buy and to sell. When thinking about the general market level as a whole, value investors tend to find that the market is fairly valued when opportunities become scarcer than before. They don't give up, they just keep looking and being patient. Opportunities are scarce in my opinion and I would encourage caution and increasing cash resources for those looking at investing in the market today.
Disclosure: The author is long SPY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.