The sometimes murky world of value got a workout in “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor” by Howard Marks (Trades, Portfolio). Chapter three saw the guru and veteran investor sorting out the many conceptions of value that can crop up.
He started with the old adage, “Buy low; sell high,” which makes sense but does not give us much direction. After all, what is low and what is high, and aren’t we all trying to do this anyway? What would help here would be objective standards for low and high. Adding “intrinsic value” certainly makes a positive difference, provided you know what the intrinsic value of a particular stock is.
To dig further, Marks noted there are two basic approaches to investing: technical and fundamental.
Technical analysis, of which Marks is no fan, is based on the interpretation of price movements and, according to the author, has been in decline since the “random walk hypothesis” emerged in the early 1960s. According to this hypothesis, a stock’s historical price moves are entirely independent of future moves; in other words, price movements are the equivalent of tossing a coin or throwing darts.
Another form of technical analysis is embedded within “momentum investing,” which presumes investors can buy a stock with a fast-rising price and later sell it to someone else, at a profit. This may work during bull markets, but inevitably a reckoning comes. Again, this approach is contradicted by the random walk hypothesis.
After ruling out technical analysis as a viable tool for investors, Marks turned to what was left: value investing and growth investing. He contrasted them this way: “In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.”
What is the inherent source of value in stocks? Many factors can be listed, everything from financial resources to brand names, but essentially, they all add up to a company’s ability to gather and coordinate them in order to generate earnings and cash flow.
For value investors, the emphasis will be on tangible factors, including hard assets and cash flow. By analyzing those factors, investors may be able to arrive at a relatively solid valuation. After reaching that valuation, it is then a matter of buying the stock at a discount to ensure there is a margin of safety. He wrote, “The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.”
As for the other kind of fundamental investing, Marks wrote, “Growth investing lies somewhere between the dull plodding of value investing and the adrenaline charge of momentum investing. Its goal is to identify companies with bright futures. That means by definition that there’s less emphasis on the company’s current attributes and more on its potential.”
He went on to argue that value investors buy stocks in the belief their value is higher than their prices. Growth investors buy stocks they think will grow quickly enough to generate future capital gains. Or, to put it another way, a choice between value today and value tomorrow.
Despite delineating these differences, Marks does not draw a distinct line of separation. Rather, he acknowledged that value investors must also speculate about the future and not depend only on current-day considerations. In large part, that’s because great companies often lose their luster over longer periods such as decades. For example, Kodak (KODK, Financial) and Polaroid (PRCDQ, Financial) were marvels of the 1980s, but who talks about them today? Perhaps, though, we will talk about them again in a couple decades, while ignoring Apple (AAPL, Financial) and Microsoft (MSFT, Financial).
Getting back to growth investing, Marks argued strategy aims to pull in big winners. Of course, growth investing is a bet on something happening in the future, and that’s always tough. For that reason, their returns should be lower than those of value investors; however, a few big winners can make up for a lot of little misses.
Value investing also has its challenges. One of the most important of them is to get the valuation right, Marks said, “Without that, any hope for consistent success as an investor is just that: hope.” Assuming you get the valuation right, there is next the challenge of holding it firmly. Marks wrote that successful investing is not about being proved correct immediately.
You might, for example, have bought a stock at an excellent discount, but the stock keeps going down to what would have been an even better discount. Some would see this as an opportunity to “average down,” but many others will see it as a stock-picking failure, an admission the crowd was right and they were wrong.
To stay the course, Marks recommends you have a tangible “something,” and that something should be “fundamentally derived intrinsic value.” He called an accurate estimate of intrinsic value the essential antidote to fear, emotion and potential losses. He wound up the chapter with these words:
“Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.”
(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.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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