Our first discussion was on the magic of compounding. If you haven't read it, please do check it out- it is important even if you don't invest because it has a lot to do with your savings SITTING in the bank.
This post will discuss about long-term investing and value investing. Before its major difference struck me, I thought both were the same. SAME. After one particular event, I realised such misconception can lead to financial loss- something that you don't want to experience.
Lets get started by clarifying a core concept - VALUE INVESTING and LONG-TERM INVESTING are 2 different approach. However, long-term investing is a subset of value investing. The opposite, though is absolutely wrong, invalid and financially fatal.
What particular event brought me to discuss this issue? In Dec'08, I was back home in Malaysia. I tried seeking for capital from friends to invest on their behalf. One of my effort led to discussion of my venture with my friend's dad - in order to gain permission from his dad for some capital. This dad of my friend is a successful businessman in his own rights. He has seen successes and recessions (in another words, businesses collapsing) and how the stock market pushes and bullies investor despite of whatever approach that guides the investor.
During the discussion, I tried to convince him of my approach, explaining my method and fundamentals and techniques and so on, so forth. Well, based on experience alone, I am next to nothing compared to this successful businessman. You might find it stupid for me to go ahead with my investment and helping people to invest (or burning their money in your terms) given my major lack of experience.Hei, I am equipped with practical advice- established for more than half a century and practiced and proven by many well-known successful investors. Don't get me wrong- I am not implying that these methods are flawless.Ok ok...this post is not about me. It's about the concept.
From the very beginning, his responses to my ideas were filled with complete pessimism. Can't blame him. THE MARKET IS REALLY IN A SHIT HOLE. This businessman was drowned in sea of pessimism due to losses in his stockholdings, slowdown in this businessman's business and stories from his wealthy friends how bad they were doing. He was even adamant that fundamentals do not work in such bad times. To be honest, even during boom times or bull markets, fundamentals hardly remain intact. When you are doing well, it's a natural tendency for you to overlook some of the flaws in your approach. Well......of course fundamentals don't work in short-term..Market tends to deviate from fundamentals - frequently. Those investors who made it big exploited this deviation by sticking close to fundamentals.......He was adamant from the very beginning that what I am doing was big-time mistakes - both in investing in current market and trying to invest people's money without experience. I accept the latter part. I lack my own experience. But the former, it's rather subjective. Time will tell. From that very point onwards, I knew my chances of gaining fresh capital is less than zero..At least through that discussion, I was enlightened in this aspect.
When someone invest for the long-term, majority will say that this is a minimum-risk and wise investment since in the long-run markets will trend upwards. True to an extent. If you think its flawless, then continue reading..
When I was discussing my approach as long-term, he started explaining the flaws of fundamentals and long-term investment. He gave me real-life examples. He described some of his investments to me - his approach, his holdings. One particular holdings of his was bought because of interaction with a very senior executive of that company - reaffirming him and the rest of the market of the bright prospects of the executive's company. Honestly, the only answer the executive can give, in summary is 'our company is on the right track and doing well-expect for more'. Who will actually provide a pros and cons comparison when trying to sell you and the rest something....It is like a foreign investor asking our Minister of Trade (not sure about the actual name of ministry and the minister's name) whether they should invest in Malaysia or not. With this, decision was made, bought the shares during boom time expecting to hold for the long term, came the market downturn, and saw his holding fall in value substantially then started blaming that long-term investing does not work. Another approach that I could recognised was buying big, blue-chip companies because they tend to go up....not wrong when you have done proper analysis...all this does not reflect proper investing. What's the lesson? Do not buy on what others say, buy based on your analysis. And, up market will eventually be followed by a down market.. nothing is permanent especially in the financial markets..
In the long-run, yes, he might recoup his losses. But one thing he cannot recover - opportunity costs. Also, how long will it take for the loss to finally break-even? Aha, time value of money. Relate to compounding and you can see the extent of losses actually incurred if the capital is wisely invested.
Hmm, took me pretty long to state my actual point. Long-term investing is only successful if you relate it too value investing. Value investing, in a nutshell is all about identifying deviations and discrepancy between price and value. Exploit it wisely and money starts snowballing into your pocket. How to exploit? Simple. Everyone does this. We buy when things are on sale. So...BUY WHEN SOMETHING IS CHEAP RELATIVE TO THE VALUE YOU ARE GETTING IN RETURN. But the problem is this- it is difficult to define value of a company. To counter this, it is not necessary to place specific figures on this value- after all, value is a subjective term. Give you Benjamin Graham's analogy - you do not need to know the weight of an obese person to tell if they are overweight or not. In simple terms, profit by buying low and selling high. We all know this. Yet, many do the opposite.
The main idea is your entry point when purchasing a share. When it is overpriced, and you buy this company, you are expecting the market to go higher (recall tech bubble in at the beginning of the century). But heated markets will cool down and things will start to collapse. So, your downside is way greater than your upside. There is still upside, but with minimum probability.
Where as if you bought it at a lower price, or a discounted price to its fair value, your downside is lower since the company has potential to unlock its value. And to make yourself feel better, when things fall, you will start saying to yourself you are buying for the long-term.
Take this for example. Your share value fell by 50% from RM100 to RM50. In order to break-even or coming back to your original position, you need to gain 100% of the current value of RM50. Assuming the general market grows by 15% annually after this downturn(this is rather quite an optimistic projection), you need 5 years to recoup your losses - assuming you do not cost-average your losses. 5 years and you only break-even...so much for long-term investing..Again, relate to compounding. Assuming capital after so many years could only be recovered at RM50. Is your actual lost limited to RM50? Not really. Factor in the opportunity costs of having the initial capital invested in bank. At a given interest rate of 3% per annum, compounded for 5 years, you will get RM115.93 in Year 5. So there is an additional loss of RM15.93. And imagine the capital was invested wisely......assuming conservative returns of 8% per annum compounded over 5 years.. you will get RM146.93 in Year 5. So...the loss actually widens substantially....bigger the compounding factor..bigger the losses..
Although buying at discounted prices to actual value is safe, this does not promise returns or complete protection from losses. What it gives you is protection or in more technical terms, higher margin-of-safety - lowering your chances of losses, NOT ELIMINATING it and increasing the potential for upside. Bigger the discount to its fair value, bigger the margin-0f-safety. Be logical and sensible- troubled companies are usually selling at distressed prices..when you buy it cheaply, you are assuming high risk of losing your capital. you got to take lots of courage to purchase such companies..Be discerning..
NOTE: the concept, margin-of-safety is extremely important, core to the heart in order to make successful investments.
Also, I am not advocating against paying a premium for good companies. Some really strong companies deserve premium. Again, it is the amount of premium that the company deserves. Take ebay. It is quiet a decent company. During the tech bubble, its premium was easily more than 2000% of its fair value....
Still can't catch why long-term investing is value investing but not the opposite? You discover price-value discrepancy (value investing), buy, hold on to it(usually for the medium to long term) until it exceeds substantially its fair value then sell and you pocket a decent profit with little risk. Where as long-term investing, you might risk overpaying or buying a company at too high a price thus having little margin-of-safety to cushion your loss if the price falls.
This is the insight I got from the discussion with that businessman. No capital, but at least a big lesson. I felt intimidated and discouraged with all his 'advice'. But hei, it sets a challenge for me to prove to him and others in the community that this method actually works- this old-skol method actually works! Hmm..come to think about it, many people has done this, but many overlooked it.....surprise surprise..human nature..
I am not just all about saying. I am actually practicing this method, putting it into use. I eat what I cook. I am putting all my faith and trust into this- my entire net worth (life time savings) is invested with these fundamentals guiding me. On top of that, I do have other investors in my informal partnership as well..not just my money. At least i manage to convince some people..
There are definitely flaws with my discussion above. So, kindly leave a comment to discuss anything and give me an opportunity to correct or clarify myself.
Hope this has enriched you and if it does, continue sticking around here to learn more.
Anyway, thanks for reading! =)
Aaron.Hee.Wy
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