How to Beat the Market
Outperformance - Value Investing - Intrinsic Value - Margin of Safety - Risk - Speculation - Market Crash
Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.
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In a previous article on long-term investment, I stated that it is almost impossible to beat the market. Over a 15-year period of time, 96% of investors underperform the market, and the figure is close to 99% if you add one decade. Long-term passive index investing is the key to grow wealth over time. However, the top 0.1% of investors beat the market over a long period. Their names sound familiar: Warren Buffet and Charlie Munger, Howard Marks, Seth Klarman, Irving Kahn, or Walter Schloss. They are all value investors, and their long track record is the fruit of skills more than luck.
At the core, value investors reject the efficient market hypothesis, which states that prices fully reflect all the available information. This theory's supposed consequence is that stocks always trade at their fair value, making it impossible to outperform the market through stock picking or market timing. However, value investing states that the market overreacts to news, resulting in price movements that don't correspond to long-term fundamentals. Any overreactions offer investment opportunities to beat the market.
Value investing was first conceptualized by Benjamin Graham his book Security Analysis (1930) and The Intelligent Investor (1949). Graham advocates analyzing businesses based on their intrinsic value. Value investors study financial indicators such as earnings, cash flow, and profit, and other factors such as competition or goodwill. The goal is then to find companies that are trading for less than their intrinsic value. There is no right number for the inherent value. Investment is an art, not a science. This process will allow the investor to buy with a margin of safety. This is one of the most crucial concepts in Graham's teachings. By buying at a bargain price, the risk of losing money is low, and returns can be high.
The quest for value investing is for cheapness. The cheaper it is, the highest margin-of-safety because if an investor overpays, it takes a strong bull market or a speculator to bail them out. Hence, the most vital route to profit is to buy cheaply relative to the business's intrinsic value. Most of today's value investors operate in a less efficient market where hard work and skill pay off more. Investor Howard Marks focus on high-yield debt and distressed debt, and Seth Klarman bought, for instance, distressed credits during the 2008 crisis. They often buy from force sellers who sell regardless of the price because of the panic or leverage. In his book The Most Important Thing, Howard Marks warns, however that price isn't all. If returns appear so generous, maybe the investor is overlooking some hidden risk. Risk management is critical for long-term success.
Value investors' views about risk are unconventional. Traditional risk theory emphasizes that it's impossible to add more returns without taking more risks. Intelligent Investors think high return and low risk can be achieved simultaneously by buying things for less than their intrinsic value. Moreover, the risk is traditionally defined by Beta, which is a measure of the volatility in the capital asset pricing model (CAPM). Graham writes that "the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation." For value investors, the real risk isn't volatility but losing the principal of the investment. Hence, they don't rely only on mathematical formulations but use a subjective evaluation of risk; investing is an art, not a science. Also worth noting, value investors focus a lot on risk-adjusted-return not just returns. An investor isn't superior to another if his high returns were made with a big risk. In this case, it's speculation, not investment.
Graham dedicated chapter 4 of Security Analysis to the distinctions between investment and speculation. He defines investment "Upon thorough analysis, an investment promises safety of principal an a satisfactory return. Operations not meeting these requirements are speculative." Graham spent a great time making fun of speculators who commit financial suicide, making money only for their brokers. Value investing books are full of funny stories of crazy speculation. For instance, in 1999, CMGI stock went up by 939,9%, while Berkshire Hathaway dropped by 24.9%. Between 1999 and 2002, CMGI lost 99.3%, while Buffet's Berkshire won 30%. Graham points at that gambling is part of human nature, and few individuals have the guts to resist. Once in a while, some speculators may win a risky bet and look up like geniuses. But as Nassim Taleb points at, one coup can arise out of randomness alone. Speculators receive the credit they don't deserve. In the world of investing, short-term gains and short-term losses are potential impostors. Only a track record of 30 years and hence the survival of several bear markets can identify a good investor. Note that it's easier to identify speculators because they usually blow up their accounts in few years. In a bull market, everyone makes money. A bear market is a better judge. As Warren Buffet says: "Only when the tide goes out do you discover who's been swimming naked."
It's challenging to come up with the right intrinsic value for a business. The hardest part is, however, to manage the investor's psychology. There is a wide range of emotions in the investment business. A bullish market is characterized by greed, optimism, exuberance, risk tolerance, and aggressiveness. A bearish market is however full of fear, pessimism, prudence, skepticism, risk aversion, and reticence. Greed is an extremely powerful force that overcomes common sense, prudence, and memory of painful past lessons. It's hard to stay prudent when every speculator around is enjoying significant profits. The combination of the pressure to conform and the desire to get rich cause investor to drop their independence and skepticism which leads to their capitulation by buying into the speculative market. The S&P500's average return from 1991 through 1999 was 20.8% per year. Many capitulated and were crushed by the 2000 crash. Greed is a drug that affects the investor's rational thinking while envy forces investors to comply with the herd. As Warren Buffet says "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.".
Value investors think that stock price movements are unpredictable. They thus agree with one hypothesis of the efficient market theory, which is the random walk theory. It states that past movement or trend of a stock price cannot be used to predict its future movement making the path random and unpredictable. Technical analysis provides no benefit and is not used by value investors. In the world, there are people who don't know and people who don't know that they don't know. Value investors don't try to predict the future. They protect themselves with a sufficient margin of safety, and they often wait patiently for the next business cycle that might offer bargains. In this sense, value investors are market timers. For instance, Berkshire Hathaway's cash position at the end of Q2 2020 stands at an all-time high of $146.6 billion. Value investor Seth Klarman justifies a large cash position by writing: "Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments."
One of the lessons of value investing is that you cannot create investment opportunities when they're not there and that reaching for yield is stupid. The only problem is that the convergence of price and intrinsic value can take time. As John Maynard Keynes pointed out, "The market can remain irrational longer than you can remain solvent.". But value investors have one conviction, which is that the pendulum always swings back, as Howard Marks wrote in his book Mastering the Market Cycle. In a bullish market, speculators believe that "this time is different" which leads to exuberance. A bubble is characterized by the fact that people believe that some new development will change the world, that patterns that have been the rule in the past, such as business cycles, will no longer occur or that the rules regarding valuation norms and standard of value and safety have changed. More often than not, this time is no different and the pendulum switches back.
If an investor started his career in the 70s, one had to live through the Arab oil embargo, stagflation, Nifty Fifty stock collapse and "death of equities" of the 1970s, Black Monday in 1987, the 1994 spike in interest rates that put rate-sensitive debt instruments into freefall; the emerging market crisis, Russian default and meltdown of Long-Term Capital Management in 1998, the bursting of the tech-stock bubble in 2000– 2001, the accounting scandals of 2001–2002, the worldwide financial crisis of 2007–2008 and the covid crash of 2020. Though times happened and will happen. These situations are likely to provide great opportunities for value investors to outperform the market.
I have learned a lot by studying value investing. I love the combination of thoughtful analysis while holding contrarian views on market cycles. As an individual investor, it is better to stick with long-term passive index investing and never buy a single stock. Value investing is a full-time job, and you can't beat the market by investing as a hobby. I have started studying value investing to understand what is a good business. Although not described in this latter, Graham and Buffet's ways of analyzing a business completely changed my perspective. I have recently finished reading almost all of Warren Buffet's annual letters to shareholders. It blew my mind. It's currently hard to think about something else, and I can't wait to apply this knowledge to my own business.
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