The 7 Deadliest Words of Investing and Why You Are Not Smarter than the Average Bear
In real estate, it’s “location, location, location”.
Apply that to investing and the closest is “valuation, valuation, valuation”.
The methods I use and share in our stock analysis software are far from perfect because valuation involves both art and science.
But then again, what is the perfect valuation method?
There’s no such thing.
And that’s difficult for many people to grasp because we are taught to do things the “right” way – a “certain” way.
One of the difficult things with investing and any form of valuation is that there is no step by step guide.
In any other industry there’s a clear process that you can follow from start to finish to accomplish a task
- Ikea furniture assembly instructions (broken link)
- Photography tutorials
- How to tie a tie
- Learning to hang glide
- and so on
But investing is like a “choose your own adventure” book that I loved to read growing up.
A choose your own adventure book is one where you come to a section of the book and you choose which adventure to take by flipping to a certain page.
Depending on your choices, the ending is different.
When it comes to investing, there is no clear single method of doing things and it can overwhelm, and frankly, freaks out some people.
Instead of a straight path from A to B, the waves of decisions and new information you have to take in requires lots of work.
And it’s too much for many people.
That’s why you always see people asking strangers what their thoughts are on a stock they hold.
But the truth is that people can invest successfully.
People can value stocks properly.
You’re just led to believe you can’t.
It’s just that there are a ton of blogs, news and articles that discuss complex ideas, causing people to simply walk by obvious low risk ideas.
I call these low hanging fruits.
Bloggers, news reporters, financial analysts all want to write about the hard stuff to get recognized. The complex deals.
Who wants to write about how a small, well run, industrial niche company in Nashville, with a 70 year long heritage that continues to gain business and generate cash?
Instead they could be writing about how Tesla is reinventing the auto industry and revolutionizing a new energy era, poring over PHD words and speculating about what the future could bring.
You’re led to believe that they must know something that you don’t.
The 7 Most Deadly Words in Investing
This is a video that I refer to when I need to clear my head of all the junk in the media or when I start second guessing myself.
I’ve marked the video to start from 1:57.
Watch the next 2 minutes to around the 3:50 mark.
Did you catch those 7 deadly words?
They must know something that you don’t.
If seasoned professionals fall into this trap, how much easier is it for regular investors to tell themselves the same thing?
Especially when they read or hear people they regard as more intelligent as themselves disagreeing with their analysis and valuations.
If you didn’t or can’t watch the video above, Prof Aswath Damodaran lays out a simple example that I certainly relate to.
You value a company. Say you come up with a value of $50 per share. Let’s say the company is Amazon. Stock is trading at $278. One of the great stocks of the last decade.
Your rational side is saying, “don’t buy that stock, it’s expensive”.
But then you hear a voice at the back of your head.
“They must know something that you don’t”.
And when you hear that voice, magical things happen to your valuation.
Your cash flows increase, your growth rates go up, your discount rates go down, $50 becomes $100, $100 becomes $150, and before you know it, guess what?
You’re at $275, $300, justifying your need to buy.
3 Types of Lemmings
Damodaran continues on to group investors into 3 groups of lemmings.
After all, we are all lemmings to some degree.
There is no such thing as a pure contrarian, because that just means you are a contrarian just for the sake of being a contrarian.
Lemming #1: The Proud Lemming
These are just momentum investors who are proud of following what’s hot. They don’t care what the company is or does. They look for a crowd and buy and sell whatever is being bought or sold.
Lemming #2: The Yogi Bear Lemming
Yogi Bear’s tagline is “smarter than the average bear” and it refers to the investors who like to think that they are able to pull out of a stock just before it crashes.
The problem is that most people claim they are smarter than the average bear, but rarely are they able to jump ship of a momentum train before it crashes.
If Isaac Newton, the father of advanced mathematics and mechanics couldn’t handle the charts, market and lemming fever, I have serious doubts about most of us.
Lemming #3: The Lemming with a Life Vest
A valuation is simply a life vest.
It’s something for you to hang onto when everyone else is doing something else.
Buffett knew that dot com stocks were at stupid valuations in 2000 and held onto his life vest when Barron’s basically called him “old”.
After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch.
To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe. Buffett, Berkshire’s chairman and chief executive, may be the world’s greatest investor, but he hasn’t anticipated or capitalized on the boom in technology stocks in the past few years.
Indeed, Buffett has even started taking flak on Internet message boards. One contributor called Berkshire a “middlebrow insurance company studded with a bizarre melange of assets, including candy stores, hamburger stands, jewelry shops, a shoemaker and a third-rate encyclopedia company [the World Book].” – Barrons
I just love how Damodaran puts it because it’s exactly how I process it.
Valuation slows the process down, gives your rational side a chance to mount an argument.
Valuation is Simple. Don’t Complicate It.
When you value stocks, you miss out on hundreds of opportunities.
Most growth stocks go out the window.
Forget about Tesla.
My article on Yelp and how it’s overvalued got rejected on Seeking Alpha because it wasn’t “trendy” enough.
Most investors don’t want to hear about valuation because it challenges their opinions.
But without a valuation to back up the story, it’s just speculation. That’s why Old School Value is meant to make valuation easy for you.
When facts and numbers over the past 5 years or 10 years are smack in front on your face, it’s difficult to fool yourself.
Unless I can find a reason for why I have to increase my valuation from $50 to $300 without solid evidence, it’s easy to recognize I’m fooling myself.
I could go into 101 reasons why everyone should use my analysis tool, but the more important thing is to start building a habit of valuing stocks.
Investing is a game where you don’t win by making all the right calls.
You can be right only 40% of the time.
But if your conviction and position sizing is good, you can easily beat anyone out there.
When I start chasing complicated stories, structures, deals, industries that I know nothing about, I’ve lost money every time.
When I focus on valuation and follow it up with patiently waiting until the stock hits my margin of safety price, I’ve been rewarded more times than I’ve been wrong.
You Can Win the Fight
Charlie Munger said that if he knew where he was going to die, he’d never go there.
You’ve just found the 7 deadliest words in investing.
They must know something that you don’t.
Fight for your life if you if find yourself going there.
In fact, I’m sharing free spreadsheet calculators you can download for free to help you with your valuation. There is a DCF, Graham’s Formula and DuPont Analysis spreadsheet calculator for you to use.
Click to enter your details and I’ll send you the calculators right away.
Valuation Course Video Series by Prof Damodaran
Lastly, if you have time, be sure to check out the rest of the short video series on valuation.
Amazing education for free.