In this missive I present a set of principles that have always guided sensible investment that, together, form what I call The Seven Immutable Laws of Investing. [Incidentally, immutable means “not subject or susceptible to change or variation in form or quality or nature.”] I hope they help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital.
So says James Montier in an article* published in frontlinethoughts.com.
Lorimer Wilson, editor of www.munKNEE.com, has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.)
Montier goes on to list the laws and comment on each as follows:
- Always insist on a margin of safety
- This time is never different
- Be patient and wait for the fat pitch
- Be contrarian
- Risk is the permanent loss of capital, never a number
- Be leery of leverage
- Never invest in something you don’t understand
Let’s briefly examine each of them:
Law #1: Always Insist on a Margin of Safety
Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes.
When investors violate Law #1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. Exhibit 1. shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000… The list consisted of ten stocks that they described as “Ten Stocks to Last the Decade” – a buy and forget portfolio. Well, had you bought the portfolio, you almost certainly would wish that you could forget about it. The ten stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley, and Genentech. The average P/E at purchase for this basket was well into triple figures. If you had invested $100 in an equally weighted portfolio of these stocks, 10 years later you would have had just $30 left! That, dear reader, is the permanent impairment of capital, which can result when you invest with no margin of safety.
Law #2: This Time Is Never Different
Sir John Templeton defined “this time is different” as the four most dangerous words in investment…. When assessing the “this time is different” story, it is important to take the widest perspective possible. For instance, if one had looked at the last 30 years, one would have concluded that house prices had never fallen in the U.S. However, a wider perspective, drawing on both the long-run data for the U.S. and the experience of other markets where house prices had soared relative to income, would have revealed that the U.S. wasn’t any different from the rest of the world, and that a house price fall was a serious risk.
Law #3: Be Patient and Wait for the Fat Pitch
Patience is integral to any value-based approach on many levels. As Ben Graham wrote, “Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants” – and there can be little doubt that Mr. Market’s love affair with equities is based on anything other than artificial stimulants!
However, patience is in rare supply. As Keynes noted long ago, “Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuations of what they hold, and on capital appreciation… and too little on immediate yield … and intrinsic worth.” If we replace Keynes’s “quarterly” and “monthly” with “daily” and “minute-by-minute,” then we have today’s world.
Patience is also required when investors are faced with an unappealing opportunity set. Many investors seem to suffer from an “action bias” – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch.
Law #4: Be Contrarian
Keynes also said that “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive.” Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive.
Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.
Currently, there is an overwhelming consensus in favor of equities and against cash (see Exhibit 7). Perhaps this is just a “rational” response to Fed policies that actively encourage gross speculation.
William McChesney Martin, Jr. observed long ago that it is usually the central bank’s role to “take away the punch bowl just when the party starts getting interesting.” The actions of today’s Fed are surely more akin to spiking the punch and encouraging investors to view the markets through beer goggles. I can’t believe that valuation-indifferent speculation will end in anything but tears and a massive hangover for those who insist on returning again and again to the punch bowl.
Law #5: Risk Is the Permanent Loss of Capital, Never a Number
I have written on this subject many times.4 In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.
To my mind, the permanent impairment of capital can arise from three sources: 1) valuation risk – you pay too much for an asset; 2) fundamental risk – there are underlying problems with the asset that you are buying (aka value traps); and 3) financing risk – leverage.
By concentrating on these aspects of risk, I suspect that investors would be considerably better served in avoiding the permanent impairment of their capital.
Law #6: Be Leery of Leverage
Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.
Law #7: Never Invest in Something You Don’t Understand
This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it.
I hope these seven immutable laws help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital.
Right now, I believe the laws argue for caution: the absence of attractively priced assets with good margins of safety should lead investors to raise cash. However, currently it appears as if investors are following Chuck Prince’s game plan that “as long as the music is playing, you’ve got to get up and dance.”
* http://www.johnmauldin.com/outsidethebox/the-seven-immutable-laws-of-investing/ (This contribution was published via John Mauldin, editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. To subscribe to his FREE weekly economic letter go to: http://www.frontlinethoughts.com/subscribe/)
Disagree? Concur? Have your say on the subject via:
We’d like to know what you have to say.