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Robert Abbott
Robert Abbott
Articles (460)  | Author's Website |

Modern Value Investing: Finding the Right Mindset

How to mentally approach the ups and downs of Mr. Market

January 10, 2019

Sven Carlin has proven one surprising thing: It is possible to be a YouTube star by talking about value investing. He’s made 587 videos and collected almost 31,000 subscribers to his YouTube channel, no small achievement for a subject area that does not involve cute kittens.

He is also the author of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” which was published last April. In it, he wrote he intended to close the gaps in value investing knowledge that have developed since Seth Klarman (Trades, Portfolio) published “Margin of Safety” in 1991. That gap, he said, was “the need for a contemporary book to account for all the changes the financial environment we live in.”

In the first part of the book, Carlin examined psychological issues that successful investors should recognize. It’s called mindset of a value investor, and he argued investors should understand four issues before applying a value strategy:

  1. You cannot make rational investment decisions when your lifestyle depends on your investments. Carlin reminded readers of Ray Dalio (Trades, Portfolio)’s advice that each asset class is likely to decline 70% or more over an investing career. Thus, a value investing strategy must have a long-term horizon to be able to ride out potential declines. In addition, for value investors to buy at the right time, they may have to hold on as these stocks drop even further before they turn up. As he observed, it is impossible to catch the exact bottom, so to get extreme bargains, you must take the longer perspective.
  2. Expect to underperform in extreme bull markets. Since value investing is not correlated with the swings of the stock market, there must be times when a value strategy underperforms the general market. Carlin cited the case of Warren Buffett (Trades, Portfolio), who was derided in the late 1990s because he did not invest in internet stocks. But after the bubble burst, Buffett was back to his customary place as top dog. In addition, Carlin was looking at 2018 as a year in which it was tough to be a value investor, but expects this strategy to minimize losses and optimize returns when a bear market returns. As he noted, “And, a bear market always comes.”
  3. Remember Buffett’s advice on fear and greed: “Be greedy when others are fearful and fearful when others are greedy."  To this, Carlin appended, “This quote is so important that it can’t be overused.” It is difficult to not be influenced by the crowd, not to want to panic when a bear arrives and hits very hard (the arrival of bear markets is usually much more dramatic than the arrival of bull markets). Value investor must stay calm and remember that recessions bring out the best risk-return opportunities.
  4. Plan to be bored. Carlin wrote, “Value investing consists of doing lots of research, saying no to thousands of investments opportunities, buying only when something meets all the criteria, and then waiting for the market to recognize the value of the undervalued investment you found.” He added the market always recognizes value—but it can take years sometimes, so the challenge is to do nothing. As Paul Samuelson wrote, “Investing should be like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”

After citing Samuelson, Carlin got into the age-old question: “Are you a value investor or a speculator?” An investor, he argued, was someone who believes long-term investment returns correlate perfectly with the underlying earnings of a business “bought in relation to the paid price”.

Carlin acknowledged his advice is easier said than practiced, and offered three perspectives on remaining unemotional:

  1. Emphasize the difference between intrinsic value and illusionary prices created by the market. He pointed to the copper market, in which speculators often trade on margin and use derivatives to leverage their trades. Therefore, they can substantially influence copper prices in the short and medium term. Nevertheless, the value of copper remains stable, and gradually rises as the world electrifies.
  2. Never buy a full position all at once. Instead, maintain a liquidity cushion. A stock may be available for less than its intrinsic value, but it is always possible for it to trade for even less. Carlin added, “Additionally, sometimes a stock price falls for very good reasons of which the value investor can be unaware. By not buying a full position immediately, the losses are limited if a change in the underlying business fundamentals suddenly arises.”
  3. Maintain a portfolio cash cushion. The liquidity cushion concept should be applied to portfolios as well as to individual securities. He used Klarman and his book “Margin of Safety” to illustrate, saying the guru was known to keep up to half of his portfolio in cash. “Having such a large stash of cash allows him to take advantage of future market pricing mistakes that always eventually arise, as sooner or later the market always enters some kind of irrational panic mode,” he wrote.

On the flip side, being greedy when the market is fearful, Carlin had these suggestions:

  1. Be convinced when markets panic. He noted history shows value investing beats growth investing in 93% of cases. Speculators, he added, rarely last more than one market cycle because they must have a buying signal from a previous market rise. As a result, margin debt peaks when the markets peak.
  2. Take advantage of Mr. Market, a character created by Benjamin Graham to illustrate the manic-depressive and irrational nature of the market. When Mr. Market is depressed, value investors jump in to buy at bargain prices; they can also jump out when Mr. Market is manic. Remember this advice from Carlin, “Mr. Market is there to serve you, not to guide you.”
  3. Markets are not efficient. The efficient market hypothesis claimed that current asset prices reflect all available information and, as a result, it is impossible to beat the market on a risk-adjusted basis without luck or without taking on riskier investments. That idea has been widely challenged, particularly by value investors who know Mr. Market is moved by many irrational forces.

Learn more about Carlin at his website or his YouTube channel.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website

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