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There are many who count themselves value investors. In fact, they are really what Seth Klarman calls “value pretenders”. It is easy to be a value pretender. I was one. Following Pabrai blindly into buying Delta Financial cost me a lot of play money. Importantly, I learned the differences between a value investor and a value pretender.

A value pretender may not realize he is a pretender. He understands the difference between price and value. He understands that Mr. Market is here to serve him. He knows he should demand a margin of safety. He admires the value investing gurus so to the point of thinking they are always right. But he does not grasp the principals of value investing.

To become a true value investor, we need to first understand the principals of value investing. Below are six principals I think are crucial for an investor to truly understand value investing:

Risk, not profit

Often, when you read a stock analyst’s report, you find the target price prominently displayed on the report. This gives investors the information he needs at a glance. The danger here is once the investor sees the target price higher than the current trade price, he skips the rest of the report and completely forgets about the risk. This is akin to lending your hammer to your neighbor because he promised to return two hammers when he still hasn’t returned the hammer you lent him two years ago.

Unlike a value pretender, a value investor does not target a specific return. Risk is what a value investor targets first. Understanding risk helps you avoid losses. Only after you understand the risks of an investment can you then calculate the rewards. An investment that promise a 50% return in one year is a lousy investment if there’s a 50% chance of the business going under in three months. But an investment promising a 20% return in one year with an 80% chance of surviving the downturn can be a wonderful investment. The rules of investing laid down by Buffett are simple — Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule no. 1.

Do your homework, but not too much

Understanding the businesses behind your investments is what separates value investing from other investing approaches. To get to know your companies well, you need to do your homework and study the fundamentals of the businesses. Doing due diligence is a pain in the butt. In Investing Mistakes - 5 Deadly Sins, I talked about the hundreds of pages of annual and quarterly reports to read, not to mention the 8-Ks and proxy statements.

But investing is one activity where you don’t get paid by the hour. Here the general 80/20 rule applies; the first 80% of the most useful information is gathered within the first 20% of the time spent.[1] Don’t strive to find the perfect information about a company. Knowing the secret recipe of Coca Cola does not guarantee a profitable investment. At some point when gathering information, you will hit the point of diminishing returns. Embrace the uncertainty and imperfect knowledge about a company that make the company a bargain. Besides, if it’s too much work, you can always pass.

Maintain discipline and patience

A value investor knows to take advantage of Mr. Market when he is being irrational. Timing the market is futile. No one can reliably predict the direction of the market let alone when the direction will change. To overcome the uncertainties, a value investor must insist on a huge discount to allow himself a sufficient margin of safety.

A riskier investment warrants a bigger margin of safety and a higher discount rate to arrive at a more conservative value. A discount rate is the rate used to calculate the current value of future cash flows generated by a business. If the stock doesn’t trade at or below your margin of safety, just don’t buy. Yes, you may miss the opportunity of a ten-bagger, but don’t forget you may as well have saved yourself from a company headed for bankruptcy. If you are patient, eventually, the price will drop to your buy price. Then, you would have made a killing. Remember, the profit is determined the moment you buy the stock. If you buy at a bargain price, you are almost certain of success.

Bottom up, not top down

Many investors continue to worry about the state of the current economy as they read about the soaring bankruptcies, the rising oil prices, the growing unemployment and the worsening housing slump. In this environment, value pretenders will predict and identify sectors that will outperform the market and begin searching for bargains there. The problem with this top down approach is you are buying based on a trend, almost to the point of speculating. You’ve decided a sector will outperform before you can perform value analysis.

A value investor understands that a company that is fundamentally strong and run by competent management will ultimately survive the downturn. Searching for a bargain begins from the bottom; you find a company and learn about the company first, not the industry. Nevertheless, there are some industries like the airline industry that are just not worth investing in. Still, if you focus on the fundamentals of a company, you don’t need to worry about the economy and market direction. In the long run, the price always converges on the value.

Change your mind

One of the most essential virtue a value investor needs is humility. Everyone makes mistakes. No one can make the right decisions all the time, not even Buffett when he sold Anheuser-Busch too early and left a big chunk of change on the table. Buffett willingly admitted he made this mistake and that is why people admire the man.

More importantly, once we learned that we have made a mistake, we must be willing to take action even if it results in a loss. The obvious case here is to sell when you realized you made a mistake in your analysis of a company. Too, when hunting for a bargain, a value investor must not get too attached to his first love. Unlike a marriage, infidelity isn’t a bad thing in investment. He may find a better bargain as he continues his search. And when he does and he has no cash available, he needs to trade his first love, even if it’s at a loss, for the better bargain. This is very, very tough to do. This is what baffles many people when gurus switch from one position to another, even though there is nothing wrong with the former position.

Absolute performance, not relative performance

Setting the right goal and focus could mean the difference between devastating losses and reasonable successes. The trouble with focusing on beating the index is we are too competitive. It is too easy to succumb to the temptation of trading just to beat the index every quarter. Ironically, this is the very reason many mutual funds underperform the index. The mutual fund managers are not entirely at fault here because if the fund underperforms the index in a quarter money starts flowing out to better performing mutual funds. The general public demand for short term performance will continue to ensure mutual fund underperformance.

On the contrary, a value investor focusing on absolute performance should do quite well in the long run. By setting aside the need to beat the index every quarter, you are forced to focus on minimizing risk while earning a decent return. If you do this well, you won’t be too far off from the index performance. Buffett uses an internal score card to gauge how he does in life. He posits, “Would you rather be the world’s greatest lover and let everyone think you are the world’s lousiest lover or be the world’s lousiest lover and let everyone think you are the world’s greatest lover?”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 102 - 115.

Side note: My recent post Index Funds - What You Don’t Know was featured on the Carnival of Personal Finance #171. This week’s Carnival of Personal Finance will be hosted by Girls Just Wanna Have Funds. Be sure to check it out on Monday.