Christopher Browne was a well-known value investor and managing director of investment manager Tweedy, Browne. His book "The Little Book of Value Investing" is an excellent source of advice for aspiring (and evolving) value investors. Today, I want to zero in on two topics that he addresses at length - his take on the idea of intrinsic value, and the idea of permanent capital loss.
Why is intrinsic value important?
Browne compared buying stocks to buying houses. If you apply for a mortgage, the bank will typically conduct an independent assessment of the property that you are aiming to purchase, and then will compare those figures with your own financial statements to determine how risky it might be to offer you a loan. Browne suggests that investors should approach buying stocks the same way - conduct a thorough analysis of the underlying value of the company, and use that information to determine whether or not it is a safe bet - to make sure that it falls within your margin of safety, that is.
“If a stock is priced way over intrinsic value, it may become vulnerable to to the “king is wearing no clothes” syndrome. This is what happened in the spring of 2000 when the technology, media and telecommunications bubble burst. Investors realised that a lot of these new age Internet stocks never had a chance of developing into real businesses with real profits that would justify their lofty stock prices. The result was a dramatic downward revaluation in of many of those “had to own” stocks”.
Beware of permanent capital loss
Warren Buffett (Trades, Portfolio) has famously said that rule number one of investing is to not lose money, and that rule number two is to not forget rule number one. Browne thought along similar lines, arguing that one of the best things about pursuing a value investing approach is that you should very rarely be in a position where you suffer "permanent capital loss":
“The consequences of the stock market revaluing overpriced stocks is often what [Benjamin] Graham and I call 'permanent capital loss.' If the stock price of a mundane company declines, which it often does, you have the comfort of knowing that it is still worth more than you paid for it, and someday the price is likely to recover. If a stock is grossly overvalued and its stock price crashes, history shows that it is unlikely it will regain its former inflated value."
One concept that many novice investors seem to have trouble grasping is that there will always be more opportunities. You don’t have to jump at every single thing, no matter how appealing it may look at first glance. In recent years, there has been a phenomenon where investors are being pushed out on the risk curve; that is, they have been taking on more and more risk to achieve the same level of return. The value investing approach calls for discipline and restraint in the face of such phenomena. Control the downside, and the upside will look after itself.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: It's Not Just What You Buy, It's What Price You Buy It At
- Jim Chanos on Tesla
- Warren Buffett: The Deck Is Stacked Against Shareholders When It Comes to Executive Pay
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