Thursday, March 22, 2007

Turning the house advantage to yours

In gambling, as in investing, a statistical advantage is what separates a winner from a patsy. And those in the business of casino never allow this basic knowledge out of their sight. Counting cards, if done correctly, gives a blackjack gambler a 1% advantage. Sound small though, but it’s enough to give a precious few a full-time profession.

Now imagine that you could get a couple of percentage advantage in investing. You could too make investing a full-time career. Few folks seriously consider becoming full-time investors, but in a way, that’s what many will inevitably do in retirement, forced or otherwise. And even if clocking out isn’t on your radar at the moment, investing is at least a side job for you, a way to earn a little more money. Otherwise, you wouldn’t be reading till this far for this article.

So gaining a couple percentage of advantage could translate eventually into a full-time investment career, you may think it sounds naïve or interesting? Well, there are a few ways to turn the advantage into your favor from the house. This results from taking advantage from market-trashing actions. So where do market-trashing results from?

For a long time, up through today in some dwindling corners, the Efficient Market Theory exercised great influence in the academic community. It holds that no one can systematically outperform the market’s returns since all information relevant to the value of the stock is instantly reflected in that stock’s price. One of the linchpins of the theory is that the participants in the market are always knowledgeable, dispassionate, rational players acting in their own interest. Because there’s so much evidence that not all investors are particularly rational, least of all knowledgeable, what has gained more influence latterly are various theories of behavioral finance.

I was reading through a presentation that noted value investor, Arnold Van Den Berg, made last spring to his clients. One part of it describes the four irrational states of sellers that you’re looking to buy from. Because no matter what form of efficient market you believe in, there’s no arguing on one point – whenever there’s a buyer of a stock, there’s a concurrent seller. And one of them is ultimately going to be proved right, and the other wrong. The more that emotion is driving the seller, the better you’ll do. So here are the emotional states you should look for in a seller.

1) Apathy: When a stock has gone nowhere for years, often sellers just don’t really care whether they own it anymore. Van Den Berg gave the example of Coca-Cola, a stock which has done nothing for its shareholders for 8 years or more. Microsoft is another company plenty of shareholders just don’t care if they own anymore, after watching the company perform well but the stock go nowhere.

2) Disgust: When shareholders lose money, or a stock has gone sideway for a long time, shareholders just want to get rid of it. The stock has disappointed you, the company’s earnings have declined, so has its sales, and you’re just disgusted with it. That is truly a deep psychological state.

3) Fear/panic: While disgust is nice, fear and panic are even better. It causes already irrational behavior even more irrational. Some classic examples of stocks getting very cheap are Merck, and Johnson & Johnson when the 1993 Hillary Clinton-led health-care plan came out. Those with their heads with them cleaned up in the wake of that panic sell-off. These companies appear to meet most of the classic value investors’ metrics today as well, though more because of apathy.

4) Anger: The forth and the best sate to find in a seller is anger. Van Den Berg claims that when his clients call him up angry over his placement of a stock in their accounts, he has his best results. He has gone back and measured that the “angry stocks” have returned 25% to his clients over his investing career. He cites Wal-Mart as the quintessential angry stock today. And I guess that Altria has to rank as one of the class in this category as well.

Van Den Berg has applied the dispassionate pursuit of great value opportunities to the phenomenal benefit of his clients. Not surprisingly, given the advantage underlying value investing, people who use behavioral states of mind are beating the market, continuously.


musicwhiz said...

Hi again !

A nice and trite article. I think full-time investing will probably not be suitable for most people as value investing is supposed to be a "get-rich-slow" method. Although it's true that by applying Benjamin Graham's margin of safety, we can find our investments delivering a "fair rate of return", the problem is that most value investors never sell. Thus, the money will be "locked up" for quite some time, and except for occassional dividends and capital reductions, there is no way for the value investor to find comfort in a steady and regular income. (I have left out investing in REITs and trusts in my argument).

As for the emotional states you mentioned, I think disgust can easily translate into anger, and it's a tenuous line between them. Of course, I do agree that value investors wait for such irrational moments when share prices are pushed far below their intrinsic values. They then scoop up a decent amount and wait for the true value of the company to be realized. Thus, this is a form of market "timing" which is to seize opportunities when others are fearful or panicky.

By the way, are you vested in any SGX cmopanies ? I notice you use a lot of USA companies in your examples, which is commendable as the market there is more mature and developed compared to our little red dot ! But the problem I have is that I am never able to get enough information about a USA company in order to properly analyze it. For SGX we have SGXNet and other forums/brokers' reports. I have been practising value investing for close to 1.5 years out of 2.5 years and so far the rewards are very tangible (though unrealized) !

Looking forward to your next posting.

Berkshire said...

Hi Musicwhiz,

I agree value investing is a "get-rich-slow" program. Full-time investing is meant for those who managed to accumulate a decent amount of sum whereby it enables one to firstly, pay oneself for his expenses, and secondly, to grow the balance. I agree that most people will not be able to do it because of the nature required out of a person to be able to practice value investing correctly. And of course the most important factor is the nature of the world whereby good things are always in small amount.

But I have to disagree with the notion that value investors never sell - perhaps more to never sell if one manage to find a great biz. Even for a great biz if a price gets ridiculous, you should sell too. A classic blopper admitted by the Sage himself, Warren Buffett, he should have sold Coke during the late 90s when it was valued at more than 60 times earnings. So now you may wonder under what situation should you sell? It key is when you think it is illogical to hold because of the price. All value investing advocates is to buy business undervalued. If you buy a so-so business at an undervalued price, you should sell it once it reach its value. This so-so business refers to business which are non-scalable in terms of both volume and price of its products. So if it goes to value, then there isn't much upside you can look forward to except for a steady yearly dividend.

On the other hand, if you buy a great business like Johnson & Johnson, chain-store retailers like Wal-Mart, Walgreens, these businesses have a scalable model, either in volume or product pricing. So these are businesses which value investor can hold forever given their competitive moat.

The bottomline in giving a gauge to an investor result lies in the return of equity of the business in the absense of an investor paying a silly price. If you buy a mediocre business even with an extremely undervalued price and you hold it long enough, you'll still only expect to get a annual return close to what the business equity can generate.

On the other hand, even if you pay a fair price for a business whose equity can produced outstanding returns, your stock performance should be in the region of what the business asset can produced.

I too agree with you that value investing of scooping up shares during depressed time is sort of a timing strategy although not exactly. I would rather think it is a strategy whereby we do not go for the game, rather, we wait for the game to come to us.

Yes, I focused much more on US businesses or businesses with a great strength. What I want is a business which has both growth and value so that I can hold my stake forever. For SG business, I do hold some through use of my CPF because CPF is only limited to investing in SG stocks. As to why I do not invest in SG stocks at this moment is because I do not see firstly, any compelling buys, secondly, no business in SG has a scaling model which is sustainable.

For SG stocks that I am holding now or those I had previously, all of them, I flip when they are cheap and flop them when they get to value. A few includes, Kingboard, Stamford Land, Unifood, Swing Media, Matex, Amtek, HL Finance, and Ossia. Now I am still holding to Electrotech, Metro and again I got back Unifood recently.

fishman said...

Hi berkshire, thanks for dropping my blog! It's great to see that you are posting again!

This topic of investors' emotion and behavior is most interesting. Personally in my short investing career of less than a year, I've already encountered two corrections, and man what a ride it was!

While I agree in buying when the price is low, I do not believe in holding on and praying for a return when market turn downwards.

Bet many investors in technology funds/stocks bought during the dotcom days are still very much in the red. So even if they have managed to hold off selling and hence not realising any losses, they would have lost much in terms of opportunity costs.