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Discipline and Value Investing

Discipline is an area of investing that gets little attention. Yet there is probably no aspect of investing that more separates successful Value Investors from all other market participants. It is also an area that everyone believes they are good at. Everyone likes to believe that they are disciplined of mind, and you will rarely hear someone confess to the opposite.

We are all tempted early in our investing life with the latest company that will “revolutionize the manufacturing industry” or “revolutionize the mobile phone industry” etc. You have read the books and heard from investment experts such as Peter Lynch and Warren Buffet (and perhaps even!) to ignore the noise - ignore the latest fad, ignore the latest “Hot Stock”. But eventually your herd mentality (which is an evolutionary phenomenon – a survival mechanism present in every human stemming from thousands of years ago) gets the better of you and you buy some shares in said company because you don’t want to be the only one missing out. Many people are guilty of this when they are young – even those who have since evolved into disciplined and successful Value Investors.

Of course, you may have conducted your own independent research and concluded that the “Hot Stock” in question is a great looking growth story with at least a few years proven sound track record, trading at a reasonable price, and a GARP (Growth at a Reasonable Price) approach is warranted. But this is rare. As I write this, LinkedIn (LNKD), which is the latest “Hot Stock”, is trading at over 400 times earnings. The herd mentality has pushed the price of the stock into the stratosphere, and it’s just a matter of when (not if) the stock price will come crashing back down to earth. Irrational exuberance exists – it always has, and always will.

In this example, if an individual recently bought shares in LNKD at, say, 300 times earnings, then that individual in a short period of time has seen his position appreciate. But let’s be very clear – the fact that the shareprice has gone up in the short term does not make this individual an intelligent stock picker (especially at buying in at 300 times earnings!). In the short term, no one knows if the stockmarket as a whole will go up or down, or if any of the constituents that make up the stockmarket will go up or down. This is contrary to what people will try to tell you.

If you bought a stock last week and it has since risen in value, and I bought a stock last week that has since declined in value, it doesn’t make you a clever equities investor, and me a poor one. If anyone knew what the stockmarket or any individual stock was going to do in the short term, they would be filthy rich. Warren Buffett has amassed incredible wealth from equities, to the point where he is one of the top 5 richest men in the world. He has done this by taking advantage of the short term stock market unpredictability – i.e. by buying undervalued stocks as the opportunity arises. He has made it very clear over decades of writing his informative and detailed annual Letter to Shareholders that he has no clues what-so-ever what the stockmarket or any stock will do in the short term. He conducts sound analysis on businesses to the point where he has a high level of confidence that the company whose stock he has bought will produce strong financial results for the coming years or decades. He is not concerned with the stockmarket – he knows that over time with the rising performance of the underlying business, its shareprice will (eventually) follow.

It is absolutely vital that you understand this point. You don’t aim to hold a position for a long period of time because: “um.. I heard that the buy and hold strategy is the best, and so I guess that is my approach…”. No, the reason that you should hold a position for a period of time, is because it can take a long time for the market to recognize the value of the stock. But be sure, it always does. You look at any company that has been financially successful over, say the last 10 years or 20 years, and have a look at its shareprice graph. Over a period of time if a company performs well as a business, its shareprice will eventually follow. There are no exceptions to this rule.

In any given week, the following could be the market news headlines:

  • Monday: “Stocks rise on solid retail data”

  • Tuesday: “Market in sell-off on negative jobs growth data”

  • Wednesday: “Stocks fall on fear of a double dip recession”

  • Thursday: “Stocks rise on a positive Obama jobs speech”

  • Friday: “Stocks tumble on fear that Greece will default”

Of course, the news writers have to write something. They are paid to come up with headlines. But no one has any idea if the market dropped because of poor jobs growth data or because the stars were misaligned, or simply because it was the month of September. On some days there may be an equal amount of positive and negative news – will the market go up or down on those days? It is very difficult to make money in the short term, unless you know in advance what the jobs growth data will be, and the retail data, and the likelihood of Greece defaulting, and….. The exception to this of course is day-trading. In the short term there is so much human emotion in the markets – predominantly fear and greed – and traders aim to exploit any patterns of market behavior caused by these emotions. But I am guessing that if you are reading this article you are not a short term trader.

Part of being disciplined is tolerating ridicule from your peers. When you invest in what you have uncovered to be an extraordinary business trading at well below its Intrinsic Value, there is a reason why it is trading at well below its Intrinsic Value. The market has developed a distaste for the stock for some reason or another, and no one knows when the sentiment of the stock will turn. If you are lucky, the market will start to look at the stock in a new light soon after you purchased it, but you should be aware that it may take months, a year or even years for the shareprice to turn around. No one knows when. It is during that period of time when the shareprice goes side-ways, or the shareprice declines from the point where you bought it (presenting an opportunity to buy more) that you need to be disciplined. Your friends and family will tell you that you have made a horrible mistake and that you should get out of the stock ASAP. You need to be steadfast in your approach – do not second guess your analysis. Instead, focus on the economic performance of the business of which you bought the shares – is it performing well? Does it still have sound Management, and promising prospects for the future as per the analysis you initially conducted? If the outlook for the company is the same as when you first completed your analysis and bought shares in the company, then there is nothing you can do except be patient, disciplined, and continue to monitor the underlying business – not its shareprice. Your friends and family can monitor the shareprice, you monitor the business.

As Warren Buffett says, “you should be willing to look foolish, so long as you don’t act foolishly”. You must be disciplined and rational, regardless of how it might look to others.

When your friends are buying dot com stocks in 1999 and 2000 and bragging how “smart” they are because their shares have appreciated in value in the short term, you need to stay disciplined in your approach. When your friends are telling you that they recently bought a trading system that allows its users to easily make “100% Return per Year!” simply by buying when the system tells you to buy and selling when the system tells you to sell, you need to stay disciplined in your approach. Remember that the vast majority of human beings want something for nothing. People want to take a diet pill instead of exercising. People want to make money from the stock market instantly without having to think, and certainly without having to exert any effort in conducting analysis of any kind. Don’t be one of those people.

All aspects of life involve effort to achieve success. Though we at USAStockValuation do not pretend to know much about trading, we do know that the best traders in the world such as George Soros devote long hours of analysis every day to their craft. Soros looks for global macroeconomic anomalies producing mispriced assets – and his success has come on the back of an enormous amount of macroeconomic analysis over a long period of time. And those that make money from trading systems do so by undertaking months or years of full time effort developing their own system and learning from the process. To be successful in any pursuit, effort discipline and the requirement to “think” cannot be substituted.

Warren Buffett often says that successful Investing is “simple but not easy”. To be successful, one simply needs to discover wonderful businesses, and buy a part ownership in each of those businesses at a reasonable price. Simple. Being disciplined is the “but not easy” part of Buffett’s phrase.

Successful Value Investors make disciplined, rational decisions based on sound analysis. They are able to block out the “noise” and focus on the process of discovering extraordinary businesses trading at very attractive prices. Value Investors enjoy and focus on the process, not on the outcome. Perhaps ironically, by not focusing on the outcome, the outcome ends up being very pleasing – an abundance of long term wealth.