To become an awesome value investor you need the right psychology, an investment plan that preserves your capital and a written strategy that is suited to your own personality and time constraints. And then to stick to these things. All the time.
Today I will make it easy for you to take action to make you an awesome value investor. All you need to do is follow the 3 steps below. Some of the steps are more difficult than others but I’m assuming that this will not matter to you because you want to take action, learn a new skill and improve your financial future.
Let’s get straight to it.
#1 Develop And Nurture Positive Psychology
This means accepting that you will sometimes lose money on the stocks that you buy. It is impossible to be correct 100% of the time so its best not to panic when your stock purchases go down in value.
This is much, much easier said than done.
I wanted to delete the sentence about not panicking when I reviewed this post before publication because it’s an area that many investors struggle with and is well known for being one of the toughest parts of investing. If not THE TOUGHEST.
When our stocks go down in value, we have a tendency to view the stock market as ‘the enemy’; always out to get you by robbing you of your money. Especially if you are just starting out. This can lead into a spiral of negative and ultimately unhelpful thinking (psychology) that is skewed towards failure. Left unchecked, investors end up developing a psychological discomfort with losing money.
Don’t get me wrong. Developing a positive psychology is not about losing money. Its about accepting that you will sometimes, but when you do, you’ll have the correct mindset to deal with it.
If you take a look at any of the holdings of value orientated professional money managers on a website such as Gurufocus you’ll notice that they hold losing stocks.
Do they panic?
Nurturing Positive Psychology
One of the best ways to start improving your psychology is to follow these 4 simple steps:
- Satisfy in your own mind that a margin of safety if strictly followed, will take care of the possibility of permanent loss.
- Practice and refine your value investing strategy for a year using a virtual account before investing real money in the stock market.
- Only buy stocks when they have a large margin of safety (see #2 below).
- Only invest with money you can afford to lose. And when you do, make sure you preserve your capital.
Need proof that value investing works? Take a look at this free report produced by well know and well respected professional money managers.
#2 Make A Margin Of Safety The Bedrock Of Your Investing Strategy
If a stock is trading at £1.50 and your intrinsic valuation (see action 3 below) is between £1.00 – £1.20, then don’t buy the stock.
If you find a stock near its 52 week low at $6.62 and your intrinsic valuation is $4.20 – $4.90 then don’t buy the stock.
Only buy a stock when your intrinsic valuation is $3.20 – $3.90 and the stock is trading at $1.43, when it is below your intrinsic valuation. Way below.
Different value investors have their preferences. Some insist on a minimum of a 20% discount to intrinsic valuation. Others insist on a 34% discount to intrinsic valuation before they buy a stock. The key idea is to only purchase a stock a sizeable distance below its intrinsic value:
A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world – Seth Klarman
Benjamin Graham liked to buy stocks at no more that 66% of their net current asset value. Walter Schloss liked to buy stocks at no more than tangible book value coupled with a low debt to equity ratio. Both men adapted their value investing strategies as their experiences of the stock market grew but as you can see, there is no hard and fast rule as to how much of a discount to intrinsic value you decide to purchase a stock at. How much risk are you willing to stomach? If its not much then insist on as large a margin of safety as possible.
The principle of a margin of safety only works when you purchase a diversified group of stocks that all trade below their intrinsic value.
How many stocks?
Anywhere between 20 and 30. There I said it. I know that some value investors like to specialise have as few as 8 or 10 stocks in their portfolio. Other like to have 30. My personal preference is to hold between 20 – 30 stocks and allocate more capital towards stocks that hold my conviction the most so that my best ideas get the most cash thrown at them.
#3 Write Down (In Full) What Your Process Of Intrinsic Valuation Is
What is intrinsic value?
An academic definition would go something like this:
Intrinsic value is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. For a less dry and rather more helpful look at intrinsic valuation using estimates of the future and an asset based approach to valuation take a look at this article by Ken Faulkenberry.
Because stocks are single units of ownership of a company, intrinsic valuation means valuing a company as a whole which includes not just cash flows, growth and risk, but also the assets that the company has ownership of such as cash in the bank, inventories or short term securities like stocks and bonds.
You can make the process of intrinsic valuation as easy or as difficult as you like. I’ve seen people do both.
The most basic form of intrinsic valuation that Ben Graham suggested is the strategy called the relatively unpopular large company. This strategy consists of the following 4 elements:
- Ensure that the company is large – $10 billion market cap for US stocks and a member of the FTSE 100 for UK stocks.
- Ensure that the company is going through a period of unpopularity – less than great trading results, a lawsuit, general mismanagement can all lead to the public’s displeasure
- Ensure that the company’s share price is declining – without a declining share price, the company’s stock will not look attractive to value investors. It needs to be cheap.
- Ensure that the company’s PE ratio is 20 or below – Anything above 20 for a large cap is considered to be a growth stock. Nothing wrong with this per se. It just means it would need a different set of criteria to value the company.
And that’s it.
In fact, the only valuation you need to do with this strategy is to find out what the company’s PE ratio is (point 4). The other three points are ‘filters’ that direct your research towards large caps that have fallen out of favour with the public.
You cannot value a stock accurately unless you either have a photographic memory or you have written down your process of intrinsic valuation (or have a simple strategy such as this one).
Finding relatively unpopular large companies means that when a large cap suffers a price decline you know exactly how to value it when it does. The fact that this strategy focuses on large caps also means that you may already be familiar with many of the companies that meet the criteria either as a consumer of their products and services, through the mainstream media or as an employee.
This resource page will help you to formulate your own process of intrinsic valuation if the relatively unpopular large company does not appeal to you. However you decide to value stocks, remember that your job as a value investor is to buy $1 for 50 cents.
To be an awesome value investor you need to take ACTION. These 3 action items will help you to focus on the most important actions to take. If you’ve used any of these strategies already or plan to do so in the future leave a comment in the box below and let me know.
Next week I’ll post 3 more fundamental actions you can take to be an awesome value investor that will take you to the next level.