28 Tips for value investing

Things I think are important

A few tips for value investors:

Tip 1: You shouldn’t have money with a short time horizon in the market

These market drops, like we’re in now, really shouldn’t impact you. In fact, this market drop should open up more opportunities, at a minimum you should be closer to opportunities than you were before.

Tip 2: Just because you have money, doesn’t mean the world has a good investment for you

I want to clarify this one, the world will have an investment for you to buy, but it might not be a good one. Just like we said with the margin of safety tip, there’s always another fish in the sea. I meet people all the time that say they want to start investing, and BAM! they are invested the next week. That’s probably not a good way to invest. The worst investment I ever made was in 2 companies that I bought because I felt like I needed to try and get my money’s worth out of my valueline subscription, so I bought the two best ideas I had. I lost money in both. Which is very unusual for me because I typically am very comfortable not buying anything for a year or so at a time. Anyways, the point is, be patient, look for slam dunks! You need to be comfortable, actually you need to enjoy learning all about a company and industry, and then doing nothing with it. One day that company might be a great buy, but it’s probably not today.

Investing is fun, but it is hard. You have to enjoy the process of learning more than you enjoy buying and selling stocks. I think most great investors would have no problem making anywhere from 0-5 investments a year.

Tip 3: Value the whole business

When looking at a business, you’re asking how much cash will this business return to owners over time. The formula for intrinsic value is the net present value of all future cash flows returned to owners from now until forever. The problem is, nobody knows the perfect discount rate to use, and nobody knows exactly how much cash will be returned. You have to figure that out. As far as discount rates go, use a higher rate than government long term bonds. Afterall, you want to outperform, so hopefully you’re higher rate helps build in more of a margin of safety. As far as cash flows go, that’s your job to figure out. At the end of the day, that’s the question that’s most important to answer. If you told me exactly how much cash a business would return to owners for any company, and what interest rates would be during that time span, I can tell you specifically what it’s worth. But nobody knows that for certain. Tim Cook couldn’t tell you what Apples earnings will be next year let alone in a decade. A value investor is able to laugh at the idea that all these analysts try so hard to forecast that with precision. You want to be roughly right in your analysis and have the low end of that roughness still tell you it’s a viable investment.

Tip 4: Buy below intrinsic value

Intrinsic value is what you think the company is worth. You want to buy a stock that you would happily buy the whole company if you had the money. Intrinsic value and market value typically are pretty close, what you’re looking for are the times when they are off in your favor. Most often, you will see intrinsic value be far below market value.

If you find a business whose stock is trading well below intrinsic value, and the stock drops more, you should be happy because now you have an opportunity to buy more of it at a better price.

Tip 5: Use a margin of safety to protect yourself from being wrong

You have to keep in mind that when you judge a business, you are predicting the future. Anytime you attempt to predict the future, there is a chance you are wrong. Because of this, if you find a business trading at 95, and you think it’s worth 100, you need to recognize that you might be wrong. You really only want to start buying it 20% below what you think it is worth. So don’t start buying it until it hits 80. And yes, this means you are going to watch lots of companies you think are worth 100, go to 100, and you will be sitting on your hands watching others make the money. That’s OK, there’s always more fish in the sea.

It is required that you are realistic with yourself in terms of how confident you are. Every company can be described optimistically or pessimistically, you need to filter it down to what’s real, what’s knowable, what’s unknowable but important, and what’s likely. Because there is uncertainty involved, you also need to diversify. You should diversify enough to compensate for your lack of confidence. If you have three business that you correctly assign a 90% chance of great returns to, you don’t need much else. But a 90% chance of success is very high. You have to make your own judgement call to figure out your odds of success. Being correct more often than not, is all it takes.

Tip 6: You have to find it yourself

Go ahead and throw out the lists and pitches. You’re looking for perfect companies that are trading cheaply. A company is going to trade poorly if 1) either nobody is looking at it, or 2) everybody is looking at it wrong. I think people are over reacting about Alibaba, so I’m claiming #2. Whenever you buy a stock, you basically have to make argument 1 or 2. If you’re getting a list, or looking on twitter, or following a well known person, those aren’t going to tend to be stocks that meet either 1 or 2.

Tip 7: ROE/ROA/ROIC > EPS

If a business is not returning cash to owners, you ask yourself if that cash being invested in activities that will allow the business to return even more money to me in the future. If a business holds $1 of earnings, and sits on it, I can likely out earn what the business gets in its savings account. If the business invests that $1 into the business to grow markets, they might easily have safe ways of earning anywhere from 12-100% returns. A great way to measure this is by being mindful of the ROA ratio. If assets are building up, but not earning, that will lower the ROA ratio. I also like the ROE ratio, there are differences in every ratio, but the big question is the same. Is the business earning good money with what it has?

Tip 8: Growth is a part of value, but cashflow to owners is what you want

Don’t get it mistaken, you want cash! Growth, can lead to greater cashflow to owners tomorrow. But you have to ask how much cash. Too often people either think of growth as this “other thing”. Growth can be good, it can be pointless. Cash flow to owners is what you want. Meta is asking us to trust them that the cash they are putting into the Metaverse today, will yield far more cashflow to owners in the future. Time will tell. Peloton had no problems growing, but owners so far see no route to ever getting cash.

Tip 9: Accounting is the language of business

Accounting is how a business talks back to you. You need to learn it. This is one of the few places I think a university is a great place to be a better investor, but you certainly can learn online too.

Tip 10: Learn to read a 10k

Companies spend a ton of time on their 10k’s. They are trying to teach you about the business. You do need to learn how to read one, it takes about an hour to read one. If you don’t know what you’re doing, it takes about a month. Just learn how to read one, you’ll get better at it over time. For this, just start doing it, you’ll get better.

Tip 11: If they want to trick you, they can

If you don’t understand a 10k, pass on the company. Accounting, business, everything, is relatively straight forward. If you really don’t understand, you should ask around. After you ask around and spend time trying to understand the accounting or business, and you still don’t, just pass. What they’ll do is hide real business problems with something confusing. If you’re confused, they’re either trying to hide something, or you just don’t get this business. Either way, pass.

Tip 12: Define your circle of competence

You won’t know everything about everything. Jim Cramer makes his money from advertisers, not stocks. You might know a lot about several industries, or maybe you only know something about 1 industry. Stick to what you know and don’t go outside.

Tip 13: You should really understand your investments

When you really understand a business, you can empathize with their problems, and get a feel for where the business is going. I’ve often felt like it really helps me predict what the business is going to do.

Tip 14: Figure out label the competition

You have to ask yourself how the business will fare in the future. If a business is earning high returns on equity, competition will likely step in and attempt to compete, eroding those high returns. What is stopping that competition? How big is the market for this business? Does the business have any natural advantages it can exploit?

Tip 15: Opportunity Cost

You have to compare everything to your best option. To start, your best option is an S&P 500 index fund. So if you’re going to invest in a stock, you need to be convinced that stock is more attractive than the S&P. Say you have 5 stocks you are convinced are better, you put the most assets into the ones that are furthest below intrinsic value, while factoring in your confidence in your analysis being correct. I’ve seen real cheap stocks that appear to be great values, but I can’t understand the business very well. Because of that, I’m hesitant to buy a lot of it. Some of them I end up being correct that it was cheap, some of them I end up being incorrect. But if you’re going to be putting big money into the stock, you need to be confident you are correct, which means you really understand the business, and all the unknowable factors around it, aren’t important.

You start with the S&P and ask do you like this stock more or less than the index. After that, you have to constantly ask, would I rather have more of my favorite stock, or this second stock I also think is better than the S&P? At a point you will own too much of your favorite stock and your fear of just being wrong will kick in.

Tip 16: Don’t over diversify

Another factor of being a good value investor is taking this difficult task and understanding that you can be too diversified. How can you outperform the S&P 500, if your portfolio owns a huge percentage of it? You can’t. The more stocks you own in your portfolio, the more likely you are to perform with the averages. In which case, why take the risk of not being simply indexed?

Tip 17: Don’t under-diversify

Just like a margin of safety, you diversify to protect yourself. The more sure you are about your investments, the less diversification you need. But you better be right.

Tip 18: Measure Your Progress

You have to see how you compare to the S&P 500. If you aren’t outperforming, you can just start buying the S&P 500. It’s easier! The only smart reason to be a value investor is to earn a lot of money, but if you aren’t earning that money, take the easy road. It’s smarter.

Tip 19: Stay in control

You have to recognize that the market is full of talented and hardworking individuals. In order to outperform you need to capitalize on your inherent strengths. Mutual funds, pensions, traders, hedge fund managers, leveraged traders, short sellers, will all be forced to sell low and buy high at times. The easiest advantage you can capitalize on is avoiding being in that position. If you leverage your holdings, you might be forced to meet a margin call and sell at a bad time. If you put money in the market you might need, you might be forced to sell at a bad time to meet your own personal cash flow needs. You have to be comfortable with cash in your portfolio if you can’t find a stock. You can sit on cash for an entire year, maybe two, maybe three, the fund manager can’t. That allows you to wait for opportunities that other investors can’t. When the crowd is selling low because they have to is often where you’ll find the best bargains.

Tip 20: Control your emotions

When markets drop, or the news is all doom and gloom, you need to be the sober decision maker. Ben Graham describes the market as a bipolar neighbor. Somedays the neighbor, “Mr. Market” is high on life, thinks everything will be amazing and there will be nothing but good news forever, on those days he will offer to sell you stocks, or buy stocks from you, for very high prices. There’s no telling how long your neighbor will be in one of his good moods, it could turn on a dime. When it does, he will assume nothing but the worst and buy your stocks, or sell you stocks, for very low prices. You know what you have to do. Everyone gets this question right on the test, can you do it in the real world?

Tip 21: Study market history

Just learning about the history of the market and various drops will help you greatly. You are human therefore you should be nervous about your emotions. Learning about the history of drops will help you control your reactions to market drops and headlines.

Tip 22: Be willing to change your mind

Think like a Superforecaster. It’s very tricky because when a stock is dropping, that’s often the time to buy more shares. However, sometimes, you might just be wrong. You need to rationally view new evidence and constantly update your intrinsic value estimate.

Tip 23: The market is there to serve you, not instruct you

Technical analysis is astrology for men. There is little to no information in the day-to-day movements of stock prices. The hard part is, most of the time, most stocks are trading at fairly appropriate levels. All your looking for is an opportunity where you find a stock, trading way out of whack with its conservative intrinsic value. Most often you will see stocks trading too highly, it’s hard to short these because even though you might be right, the stock could keep going up and force you to sell at a bad time. The market will drop on you, rise on you, stay flat, just ignore that. Stay focused. All you’re looking for are stocks that are trading below what they are worth. Don’t worry about why they are trading so cheaply. Worry about if you missed something in your analysis. The best stocks are either stocks that everyone is looking at wrong, or even better, stocks that nobody else is looking at.

Tip 24: If it looks like BS, and it smells like BS…Please don’t taste it

If I had to boil it down to two things. I would predict anyone that 1) can control their emotions, and 2) detect BS, would do just fine as an investor. Often times you’re reading a 10k and it makes no sense, just pass. Or you hear a stock pitch and the person telling you about it gets angry that you don’t agree, just pass. People will sell you BS all the time. We all get multi-level marketing pitches, that doctor in South America with a good soul doesn’t know how to cure diabetes, he just doesn’t. And if he does, you're not in a position to answer why western medicine hasn’t picked up on it.

Tip 25: Think for yourself

You can’t outperform by doing what everyone else is doing. You’ll need to think for yourself. That means sometimes you will agree with everyone. Sometimes you will disagree with everyone. The only justice is in the fact that being right is all the matters. You can’t enjoy disagreeing or agreeing with everyone, you have to just be adamant about thinking for yourself while also, learning from those who deserve to be studied.

Tip 26: Learn something everyday

Investing is a mix of predicting the future and making bets. I liken the bets to being more like the house than the person at the casino table. If you’re a patient investor, the odds are on your side that over time you will do well. If you’re a trader, you’re more like the guy gambling at the table, the odds are against you. But if you want to predict the future well and make good bets, it will help you to have a great understanding of the world. Learn everything you can about everything. I personally believe any reasonably smart person can learn 80% of near any field with reasonable effort. It’s that last 20% that is reserved for experts, I think good investors think this way. And it’s fun.

I think it’s important because in essence if you don’t enjoy learning about something for the sake of learning about it, how will you look at stocks and not invest? Maybe they aren’t related but to me they are. All the time I look at stocks and study them, review the competition, and then don’t do a thing! And it’s fun.

Tip 27: Keep a wish list

Google, Microsoft, Amazon, Apple, Berkshire Hathaway, are all undisputedly great companies. The trick is, are they currently trading below a conservative estimate of intrinsic value? You won’t miss a big drop in their market caps because the aforementioned firms are always in the news. However, all the time you will find other wonderful companies who are just trading at an expensive price. Keep a shopping list of those firms, every now and then Mr. Market will offer them to you surprisingly cheaply. If it’s a truly great firm, they will be a great firm for many years. Maybe 4 years from now you wake up and one of them becomes a great buy. Keep a wish list and wait for a sale.

Literally, write them down. Whenever there’s a big market drop, take a look at them and see if one of them is getting punished, then go make sure it’s still a wonderful firm, and if it is, you should enjoy what comes next.

Tip 28: Learn from the GOAT

The greatest investor of all time wants to be remembered as a teacher. Do yourself a favor, learn from him. Warren Buffett puts out great letters every year and has all sorts of speeches on YouTube. You can get nearly everything he’s ever written for free. If you see Buffett say something that contradicts what you think, presume you’re wrong. Read his Forbes article titled “Inflation Swindles the Average Equity Investor” I think it’s his individual best work. Feel free to post your favorites in the comments.

Hope everyone has a great Thanksgiving tomorrow!