Intrinsic value is the worth of an enterprise to one who owns it for keeps. Logically, it must be based on the cash flow that would go to a continuing owner over the long run, as distinct from a speculative assessment of its resale value.
Warren Buffett says that the best investment course would teach just two things well:
- How to value an investment and
- How to think about market price movements.
“In the long run, the market gets it right. But you have to survive over the short run, to get to the long run”
The Most Important Thing Illuminated
Howard Marks
To become reliably successful in investing, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.
Prices can deviate wildly from value over the short run. However, understanding the psychology so that you can take advantage of these deviations when they appear is the hard part.
The oldest and fundamental rule in investing is also the simplest. You must buy at a price below intrinsic value and sell at a higher price. The most dependable way to make money is buying something for less than its value. Buy low; sell high.
The first building block of value investing is knowing the intrinsic value of what you are buying. The emphasis in value investing is on tangible factors such as hard assets and cash flows. There is less weight placed on intangibles such as talent, popular fashions, and long-term growth potential.
What is Risk?
Risk means more things can happen than will happen according to Elroy Dimson. The key to understanding risk is that it is largely a matter of opinion. It’s hard to be definitive about risk, even after the fact.
An important concept in investing is comparing the risk of permanent loss of capital to the potential reward. In other words, the risk of permanent capital loss is the only risk to worry about.
There’s a big difference between probability and outcome. Probable things fail to happen-and improbable things happen all the time. That’s one of the most important things you can know about investment risk. What we think will happen, might not and what we think will not, may happen.
Howard Marks tells his father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. The moral of the story is that risk is always unknown and in the future.
The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. A high price increases the risk and lowers the returns.
Most investors think quality, as opposed to price, is the determinant of whether something’s risky. However, it is possible that high-quality assets can be risky, and low-quality assets can be safe.
A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference.
Even though you cannot predict, you can prepare. We never know what lies ahead, but we can prepare for the possibilities and reduce our losses.
Dangers of overconfidence
There are two kinds of people who lose money: those who know nothing and those who know everything.
It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.
You must acknowledge the boundaries of what you know. You must work within those limits rather than venturing beyond. You must be very careful with your own forecasts and even more careful with those of others.
You may never know where you’re going, but you better have a good idea where you are. You must learn to be honest with yourself about your successes and failures. You need to learn to acknowledge the role of luck in all your outcomes. You must be able to separate outcomes that came about because of skill and which because of luck.
Cycles
Most things in this world follow a cycle. History repeats itself. The basic reason for the cyclicality in our world is the involvement of humans.
Mechanical things can go in a straight line. Time moves ahead continuously. With the involvement of humans, fields such as history and Economics are variable and cyclical.
Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. In other words, success (upsides) carries within itself the seeds of failure(downside), and failure(downside) the seeds of success(upside).
It becomes extremely dangerous when there is a consensus among investors that things can only get better forever. This is what creates bubbles and just as the opposite produces crashes.
Charlie Munger says that “Nothing is easier than self-deceit. For what each man wishes that he also believes to be true. The belief that some fundamental limiter is no longer valid-and thus historic notions of fair or intrinsic value no longer matter-is invariably at the core of every bubble and consequent crash.
As it turns out many of the mistakes, we have made are the same ones that we had made before. They look a little different each time. But are invariably the same mistakes slightly disguised.
Mujo in Japanese means cycles will rise and fall, things will come and go. And our environment will change in ways beyond our control. Thus, we must recognize, accept, cope, and respond accordingly.
Defensive investing
The defensive investor focuses on not doing the wrong thing rather than doing the right thing. You must know what to avoid. It is important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
if you can avoid the losers, the winners will take care of themselves. As Warren Buffet says an investor needs to do very few things right as long as he avoids big mistakes.
My Take
The most important investment principle is knowing what to avoid. By avoiding big mistakes, the winners will eventually compound into great wealth.
Practical Insights
- Know your circle of competence.
- You must know what to avoid.
- Your biggest risk in an investment is losing your capital.
