Getting Started In Value Investing

Chapter 3: Market Caveats: Lessons from the Past

• On April 14, 2000 the NASDAQ had dropped 35% from its all-time high of 5,132 which was
established only 26 days earlier
• There are many theories why such a steep correction took place in such a short period of
time, but the most accurate is excessive valuation levels in equities
• During the 1990’s many analysts said that traditional rules of valuation did not apply, but
the violent market decline proved that on Wall Street there is never a “new paradigm”
• The author believes there are three lessons that investors should take from the 2000 market
decline
• Lesson 1: It’s not a blip!
• Stock price and business valuation are two entirely different things
• Just because a stock price rises or falls does not mean that the financial
strength of the company has changed
• Investors increasingly are taking a much shorter term view of financial
markets
• In 1973 the typical investor held a stock for 5 years today that duration has
shortened to 11 months
• Lesson 2: Mr. Market is Mental!
• Mr. Market is not a good appraiser of businesses
• During periods of rising prices he overpays for companies and in times of
market turmoil he will sell businesses for much less than their true value
• The author uses the example of Inktomi which in 2000 had a value of $25
billion and by 2002 it had been revalued to $40 million
• A year later Yahoo bought the whole company for $280 million
• The stock market is there to serve the investor not the other way around
• “The primary cause of failure is that they pay too much attention to what the
stock market is doing currently.” – Benjamin Graham
• “Be greedy when others are fearful and fearful when others are greedy.” –
Warren Buffett
• Lesson 3: Price Is the Biggest Factor
• “The really dreadful losses . . .were realized in those common-stock issues
where the buyer forgot to ask, ‘How much?’” – Benjamin Graham
• A great company can be a lousy investment if you pay too much for its stock
• The author describes his research process as the following
• Try to figure out what the company does and how it makes money, and why I like it.
• Realize that a stock represents plants, employees, products or services, production,
competition, and management.
• Look at the financials of a company and ask, “Do I want to be in that business?” If the
answer is no, move on.
• If he can’t understand the business, he puts it in the “too hard” pile.
• “There are all kinds of businesses that Charlie [Munger] and I don’t understand, but that
doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the
individual investor should do.” – Warren Buffett
• In the short term stock prices can bounce around aimlessly, but over time increased
earnings will cause a companies stock price to rise
• Best to focus on long term earnings not daily gyrations of stock prices
• “Over the short term the stock market is a voting machine, (prices rise based on popularity),
but over time the stock market is a weighing machine (stock prices will eventually go up, based
on their earnings).” - Warren Buffett quoting his teacher Benjamin Graham
• The author believes that over diversification is one of the biggest causes of mediocre
investment performance
• “Concentrate; put all your eggs in one basket, and watch that basket.” – Andrew Carnegie
• “As time goes on, I become more convinced that the right method of investing is to put fairly
large sums into enterprises which one thinks one knows something about and in management
of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading
too much between enterprises about which one knows little.” - John Maynard Keynes
• A concentrated investor emphasizes the importance of understanding a business before
making a purchase, and then invests a substantial portion of their capital
• “If you have a harem of 40 women, you never get to know any of them very well.” – Warren
Buffett
• “It never seems to occur to [investors], much less their advisors, that buying a company without
having sufficient knowledge of it may be even more dangerous than having inadequate
diversification.” – Philip Fisher
• “Diversification is only a surrogate, and usually a damn poor surrogate for knowledge, control
and price consciousness.” - Martin Whitman, Third Avenue Management
• The best way to mitigate risk is to invest in quality companies after developing an
understanding of the business model
• “If you are a know-something investor, able to understand business economics and to find five
to ten sensibly priced companies that possess important long-term competitive advantages,
conventional diversification makes no sense for you.” – Warren Buffett
• Great companies rarely trade at fair or discount prices so it is important to load up on them
when the opportunity arises
• “If you really know businesses, you probably shouldn’t own more than six of them. Very few
people have gotten rich on their seventh best idea. But a lot of people have gotten rich with
their best idea.” – Warren Buffett
• Charlie Munger has suggested that three companies is all that is needed in a
portfolio
• The author suggests an investor identify the characteristics of a great business and then
review the financials of the business in order to find out how the company makes money
• “Investing is most intelligent when it is most businesslike.” - Benjamin Graham
• Investors should focus on businesses that they understand and have a history of consistent
operating earnings
• “Never invest in any idea you can’t illustrate with a crayon.” – Peter Lynch
• The key variables are those that will impact sales, earnings and cash flow
• If an investor can’t figure out what the company does in five minutes he should move on
• “Investors should remember that their scorecard is not computed using Olympic-diving
methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is
largely dependent on a single key factor that is both easy to understand and enduring, the
payoff is the same as if you had correctly analyzed an investment alternative characterized by
many constantly shifting and complex variables.” – Warren Buffett
• Projecting future earnings is very difficult and therefore it is very important to stay away
from companies that have erratic earnings histories
• An investor must be confident that a companies earnings over the next five years
will not be significantly different than the previous five years
• “Predictability is a key part of valuing a company, with value determined by the amount of cash
an enterprise can generate over time. If you can’t understand the business, you can’t value it. If
you can’t value it, you shouldn’t own it.” - Larry Coats, Jr., Co-manager of the Oak Value Fund
• Key Points
• Asking the basic questions is the key to finding real value. Do you understand the
business? Who are its managers? Is the company’s operating history consistent and
predictable?
• The market is completely irrational and overreacts to just about everything. Were
the market a person, it would be diagnosed as bipolar. So “following” the market is a
big mistake ... but a very common one.
• Diversification works best on a small scale, best applied in the small realm of
businesses you understand thoroughly. You don’t need 30 to 40 different stocks;
less than 10 is ideal and certainly no more than 20.