The stock market's surge since March may lead some investors to become less disciplined when managing their portfolios. For example, they may invest in industries that they do not fully understand due to bullish sentiment among their peers. Or, they may purchase companies for significantly more than their intrinsic values due to overly-optimistic forecasts.
This may lead to an inefficient allocation of capital. Therefore, in my view, following investors such as Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice-chairman Charlie Munger (Trades, Portfolio) could be a good idea.
Munger has benefitted from sticking with a structured investment strategy throughout a range of market conditions. His focus on buying companies with competitive advantages at low prices may have contributed to Berkshire's long-term outperformance of the S&P 500.
A circle of competence
Rising stock prices can tempt any investor to expand their holdings into new areas. For instance, they may decide that large-cap technology companies have the strongest growth potential in the stock market. However, their operations can be very diverse and complicated. Therefore, it can take time for an investor to fully understand them.
Although diversification is an important part of investing that can reduce risk, so too is staying within your circle of competence. This enables you to more easily find mispriced opportunities for quality businesses that can lead to an efficient allocation of capital.
As Munger once said, "The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much. You're going to fail through lack of specialisation."
A competitive advantage
The stock market's rise may encourage investors to speculate on its future performance. They may wrongly assume that recent upward trends will continue uninterrupted, or that they can make a quick profit before the next bear market comes along.
In my view, this is a dangerous strategy than can lead to large losses. A better idea is to remind yourself that every stock listing is not just a name and ticker symbol. It is a company that makes products or provides services.
Therefore, buying those companies that have a competitive advantage over their rivals could be a prudent strategy at a time when the economic and political outlook is particularly fluid. They may be better able to withstand a period of difficult operating conditions.
As Munger previously said, "The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage."
Investing in undervalued businesses
Valuing stocks may be more difficult today than it has been for many years. An uncertain economic outlook and poor financial performances from businesses this year means that asset prices and recent levels of profitability may not be as useful in determining a company's intrinsic value as they have been previously.
However, in my view, it is still crucial to value a company before buying it. For instance, this may be done by using its performance over the past few years, rather than this year's exceptional results.
Once you have estimated the value of a company, it is easier to determine whether it offers good value for money at its current price. Even though stock prices have risen sharply in recent months, having the self-discipline to avoid overvalued securities may be a prudent approach given the geopolitical outlook.
Munger has always sought to estimate a company's intrinsic value before purchase. As he once said, "All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock."
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Warren Buffett on What Makes a Successful Value Investor
- Joel Greenblatt on Managing Your Portfolio in a Bull Market
- Seth Klarman on Risk Versus Reward
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
