I wrote the core of this piece in preparation for a speech I gave at an investment conference. In my speech, I wanted to show how at my firm, we took the Six Commandments of Value Investing and embedded them in our investment operating system.
Since I was speaking to fellow value investors, this speech was written not to promote my firm but to educate. I was going to rewrite the speech for this chapter and make a bit less about us and more about you –but each attempt resulted in a dull chapter. So here is a much extended version of my original speech.
The Six Commandments
These are the Six Commandments of Value Investing. I don’t expect any value investors reading this to be surprised by any one of them. They were brought down from the mountain by Ben Graham in his book Security Analysis.
1) A stock is fractional ownership of a business (not trading sardines).
2) Long-term time horizon (both analytical and expectation to hold)
3) Mr. Market is there to serve us (know who’s the boss).
4) Margin of safety – leave room in your buy price for being wrong.
5) Risk is permanent loss of capital (not volatility).
6) In the long run stocks revert to their fair value.
These commandments are very important and they sound great, but in the chaos of our daily lives it is so easy for them to turn into empty slogans.
A slogan without execution is a lie. For these “slogans” not to be lies, we need to deeply embed them in our investment operating system – our analytical framework and our daily routines – and act on them.
The focus of this chapter goes far beyond explaining what these commandments are: My goal is to give you a practical perspective and to show you how we embed the Six Commandments in our investment operating system at my firm.
1. A stock is partial ownership of a business
The US and most foreign markets we invest in are very liquid. We can sell any stock in our portfolios with ease – a few clicks and a few cents per share commission and it’s gone. This instant liquidity, though it can be tremendously beneficial (we wish selling a house were that easy, fast, and cheap), can also have harmful unintended consequences: It tends to shrink the investor’s analytical time horizon and often transforms investors into pseudo-investors.
For true traders, stocks are not businesses but trading widgets. Pork bellies, orange futures, stocks are all the same to them. Traders try to find some kind of order or a pattern in the hourly and daily chaos (randomness) of financial markets. As an investor, I cannot relate to traders –not only do we not belong to the same religion, we live in very different universes.
Over the years I’ve met many traders, and I count a few as my dear friends. None of them confuse what they do with investing. In fact, traders are very explicit that their rules of engagement with stocks are very different from those of investors.
I have little insight to share with traders in these pages. My message is really to market participants who on the surface look at stocks as if they were investments but who have been morphed by the allure of the market’s instant liquidity into pseudo-investors. They are not quite traders – because they don’t use traders’ tools and are not trying to find order in the daily noise – but they aren’t investors, either, because their time horizon has been shrunk and their analysis deformed by market liquidity.
The best way to contrast the investor with the pseudo-investor is by explaining what an investor is. A true investor would do the same analysis of a public company that he would do for a private one. He’d analyze the company’s business, guestimate earnings power and cash flows. Assess its moat – the ability to protect cash flows from competition. Try to look “around the corner” to various risks. Then figure out what the business is worth and decide what price he’d want to pay for it (your required discount to what the business is worth). For an investor, the analysis would be the same if his $100,000 was buying 20% of a private business or 0.002% of a public one. This is how your rational uncle would analyze a business – your Warren Buffett or Ben Graham.
How do we maintain this rational attitude and prevent the stock market from turning us into pseudo-investors? Very simple. We start by asking, “Would we want to own this business if the stock market was closed for 10 years?” (Thank you, Warren Buffett). This simple question changes how we look at stocks.
Now, the immediate liquidity that is so alluring in a stock, and that turns investors into pseudo-investors, is gone from our analysis. Suddenly, quality – valuation, cash flows, competitive advantage, return on capital, balance sheet, management – has a much different, more complete meaning.
This important question also brings up the next value investing commandment: having a long-term time horizon – but not just from the perspective of analyzing a company. We’ll discuss it in more detail in the next part.