If Value Investing is so good then why doesn’t everyone do it?!?!

Investment Perspective – January 2018

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price…the cash up value. What matters more is the economics of the business” 

Peter Flannery

I have heard this question numerous times in the past.  It usually comes from those who don’t understand the essence of Value Investing or who have locked in a particular way to invest that is not Value Investing, or else they invest in residential property and believe the stereo-typing around the sharemarket being like going to the races or a game of chance like Lotto.

People believe what they allow themselves to believe.

Another reason is that mainstream investing is based around Modern Portfolio Theory (MPT) which basically says that investors should diversify as widely as possible and that volatile trading prices or declining prices mean risk – to be avoided. 

One of the challenges that everyone faces is the risk of buying into or believing superficial evidence that is usually based on self-interest or short term data that tells a story that an investor might like the look of. 

Another challenge is believing that certain results or returns in the past are an indication or guarantee of what will happen in the future.  This is especially dangerous when those results from the past were actually driven by an unusual set of circumstances that will not last (e.g. declining interest rates and easy money conditions over the last 30 years or so).

We often read about or see on popular media those rare stories where someone made a lot of money quickly doing something that was unusual.  This attracts those with the so-called “microwave mentality” who want quick solutions without any work or pain.  Get rich quick suits them just fine! 

Common investment mistakes

First up would be those “investors” who default to investing in term deposits in the bank because (they think) it is safe.  OK short term but not OK long term.

Next are those at the other end of things who chase big short term (easy) returns. 

They like to invest in technology stocks, hot property markets, tips from newsletters that offer a compelling argument, usually based on nothing more than a theory or a clever sounding idea.  That’s because those type of investors readily buy into the idea that it is possible to make money quickly and get rich with a “king hit”. 

It can happen and we read about it when it does.  We read about it because it’s rare.  To be clear, it is not a reliable way to build sustainable wealth long term.

Another mistake that is very common would be an adherence to Modern Portfolio Theory.  I suspect that many people who save in KiwiSaver here in New Zealand have no idea that Modern Portfolio Theory is the methodology used to invest their money. 

Amusingly, when someone explains the idea of diversification it sounds so believable and so right.  Of course, it is valid.  That doesn’t mean that it’s right. 

Value Investing versus Modern Portfolio Theory

Indeed, they are each at opposite ends of the investment spectrum. 

On the one hand Modern Portfolio Theory is about diversifying as widely as possible and minimising pricing volatility at every turn.  The idea is that volatile prices or prices that decline are high risk and to be avoided.

Strange but true

Honestly(!), to suggest that low prices mean more risk is simple minded at best – stupid when we really look closely at it. 

Obviously if we are looking to invest in a poor quality asset then low prices indeed can be high risk however that’s not our game.  We are looking to invest in quality assets.  Just because the price declines, that doesn’t mean that the economics of that business are all of a sudden no good.

Warren Buffett’s explanation clarifies it quite well: 

“The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of 10 buyers for not less than $400 million, probably appreciably more …  Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta (a measure of an assets pricing volitility or risk) would have been greater – the higher the beta, the higher the risk.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million …”

There is a lot of talk in investment circles about alpha and beta (most, if not all fund managers in NZ use alpha and beta to manage Kiwi saver and employee super schemes). 

It seems that the more complicated the “investing science”, the more elegant the mathematics and the more clever sounding the articulation of the investing parlance, somehow the more intelligent and the more right you will be as an investor if you invest like that! 

I don’t get it either.

“If it (the strategy) requires a spreadsheet, it’s a big red flag.”

Mohnish Pabrai from his book The Dhantro Investor