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The most important thing is the relationship between price and value. It's not by buying good things that we succeed in our investments, but when we buy things well. Imagine we are convinced of the effectiveness of value investing and we manage to estimate the intrinsic value of a stock or other asset.
Let's say the estimate is correct. We're not finished yet. To know which stock to buy, it 's necessary to analyze the asset's price in relation to its value. Establishing a healthy relationship between fundamentals, value, and price is one of the main elements of good investing. Price should be the starting point for the value investor.
It's a known fact that no asset is so good that it ca n't become a bad investment if bought at a very high price, and there are few assets so bad that they ca n't be a good investment. When people categorically say " we only buy A" or "A's is a superior asset class," that's just a mistake. It's like saying we would buy A at any price, and we would buy B before C or D.
That can only be a mistake. No asset class or investment possesses high rates of return merely by its origin. They will be attractive if their price... If it is correct when I put my car up for sale, I hope the potential buyer wants to know the price before accepting my offer. It would be equally foolish to decide on an investment without carefully considering whether its price is fair or not.
This is exactly what people do when they decide, without any disciplined value assessment, that they want to own something, as happened with technology stocks in the late 1990s, or when they simply decide they do n't want something, as they did with speculative bonds in the 1970s and early 1980s. In short, there is no good or bad idea, regardless of whether the most important premise is that if we buy something at its fair value, we will obtain an adequate return given the risk.
But active investors are not in this activity to obtain fair risk-adjusted returns; they want superior returns if there is satisfaction with fair returns. Why not invest passively in an index fund and avoid several problems? It is very common to buy at intrinsic value and pay more for something than it is worth; this is clearly a mistake.
It takes a lot more. It takes work or a lot of luck to transform something bought at a very high price into a good investment. Remember the investment in NIFTFs that I described in the previous chapter? At their peak, many vigorous, leveraged companies, according to the model, boasted conscious price-earnings ratios.
The ratio between the share price and earnings per share was between 80 and 90. For comparison, the average post-war price-earnings ratio for stocks generally hovered between 15 and 17. None of the investors in this model seemed concerned with such high valuations. Then, in a short time, everything changed.
In the early 1970s, the stock market cooled down due to exogenous factors. As the oil crisis and rising inflation clouded the overall picture, NIFTF stocks collapsed. Within a few years, price-earnings ratios of 80 or 90 fell to 8 or less. Investors in the best American companies had lost 90% of their money.
Although people bought shares in large companies, they paid the wrong price. We usually say that you can only sell well what you buy well; we don't spend much time thinking. The price at which we will be able to sell, nor when, nor to whom, nor by what means, if we buy at a low price, this information will be obtained.
At some point, in any case, if the estimate of the intrinsic value is correct, the price of an asset eventually converges to its value. How much companies are ultimately worth boils down to this: it's not enough to buy a share of an idea, or even a stock; you need to buy at a reasonable price, or if possible, at a bargain price.
( pincha.bubble.com, January 3, 2000) All this raises the question of how the price is composed, what a potential buyer should pay attention to in order to be sure that the pricing is correct, the underlying fundamental value is clear, but most of the time the price of an asset will be affected in the same way by two other factors: psychological and technical.
What will primarily determine short-term fluctuations? Most investors understand this. Undoubtedly, amateurs know little about technical factors; these are not considered fundamental. That is, it is inferred that they are not linked to value to affect the supply and demand for assets. Two examples are forced selling, which occurs when...
Market crises cause leveraged investors to receive margins that force them to sell at very low prices, and the inflow of money into mutual funds forces managers to buy. In both cases, people are led to trade assets without considering the price. Believe me, there's nothing better than buying from someone who, during a crisis, needs to sell regardless of the price.
Many of the best purchases we've ever made in the world occurred for this reason. However, we must make two observations: there's no way to build a career buying from people forced to sell and selling to those who are compelled to buy. These opportunities aren't around all the time, only on rare occasions at the extremes of crises and bubbles.
And since buying from those forced to sell is the best thing in the world, being one of those sellers is the worst thing. This means it's essential to organize trades so that it's possible to maintain our position and not sell even in the worst moments. This requires long-term capital and strong psychological resources, and this leads me to the second factor that exerts a strong influence on the price: psychology.
It's impossible to exaggerate its importance; in fact, it's so vital that I dedicate several chapters to discussing it. The psychology of investors and how to deal with their manifestations: while qualified financial analysis is key to determining value, understanding the price-value ratio and its prospects largely depends on perceiving how other investors think.
These investors, for psychological reasons, can cause the price of an asset to settle at any level in the short term, regardless of its fundamentals. The most important discipline is not accounting or economics, but psychology. It's important to know who likes and dislikes the investment at this very moment.
Future price changes will be determined by the appreciation of assets by more or fewer people in the future. Investing is like a popularity contest where the most dangerous action is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into the price, and no new investors appear wanting to buy it.
The safest and potentially most profitable action would be to buy when the asset is not desired by anyone. Over time, its popularity, and therefore its price, can only follow a random pattern. From 1994 onwards, this is clearly another area of critical importance and extremely difficult to master. Firstly, psychology is elusive, and secondly, the psychological factors that affect the minds of other investors influence their actions and will also affect us, as we will show in later chapters.
These forces tend to lead people to act in a way that is the opposite of a competent investor. So, in order to protect ourselves, we must invest time and energy in understanding market psychology. It is essential to learn that fundamental valuation will only be one of the variables that will determine the price of an asset on the day of its purchase.
We also need to keep technical and psychological factors on our side. In opposition to conscious value investing, we have the indiscriminate pursuit of bubbles in which the price-to- value ratio is completely ignored. All bubbles begin with some grain of truth: Tulips are beautiful and rare in 15th-century Holland; the internet will change the world; real estate investment is capable of keeping up with inflation; besides, we can always live in a house.
Some intelligent investors discover, or perhaps even predict, these truths, invest in the asset, and then begin to profit. Others understand the idea, or They only realize that people are making money and also buy, raising the asset price. However, as the price rises, they feel increasingly encouraged by the possibility of making easy money and evaluate the price's appropriateness less and less.
This is an extreme interpretation of the phenomenon I described earlier. If people should appreciate an asset less when its price rises in the investment arena, however, they tend to like this type of asset more. Between 2004 and 2006, for example, good things were said about real estate investments: the desire to participate in the American dream of homeownership, the ability to benefit from inflation, the fact that mortgage loans were cheap and payments would be deductible, and finally, the popular knowledge that house prices only increase.
We know what happened to that little pearl of wisdom. What to say about the infamous idea that there's no way to lose with this investment in the tech bubble? Buyers weren't worried about high stock prices because they were sure someone would always be willing to pay more for it. Unfortunately, the theory that there will always be someone more foolish works until the moment it stops.
At some point, valuation becomes part of the game, and those holding many worthless shares will have to face the consequences. The positive aspects of shares may be genuine, yet still produce losses if the price paid for them is too high. These positive aspects and the enormous profits that everyone else apparently sees obtaining may eventually cause those resistant to participating in the business to surrender and buy a share.
A group or market reaches its peak when the last hesitant investor becomes a buyer. The moment this occurs is not usually related to the evolution of fundamentals. Prices are very high, and this is far from being synonymous with the next movement being downward. There may be overpricing and its maintenance for a long time, or the assets may become even more expensive at some point.
However, valuation ultimately prevails. babble.com AB bubble.com January 3, 2000. The problem is that in bubbles, attractiveness becomes attractive at any price. People often say, "It's not cheap, but I think it will continue to rise because of excess liquidity or for any other number of reasons." In other words, it is said, "It's expensive, but I think it will get more expensive to buy or hold the position." Basing this reasoning on this principle is extremely risky; however, this is how bubbles work.
The moment they form, passion for the market moment outweighs any notion of value and fair or adequate price, and greed, along with the difficulty of doing nothing while others make seemingly easy money, neutralizes any prudence that would otherwise prevail. In short, the investment strategy is more about creating a bubble than others, making it less accurate for investors to benefit from the asset's increase.
The problem is that increases in value are difficult to predict accurately. Furthermore, conventionally, assets already include potential increases in their prices. This means that unless we have a different, better view than the consensus, we are likely already paying for potential increases. In certain investment areas, most notably in private equity and real estate, controlling investors can strive to create increases in value through active asset management.
This is worthwhile, but it is time-consuming and uncertain, requiring highly specialized professionals. Furthermore, it can be difficult to improve, for example, a company that is already good by applying [something - the sentence is incomplete]. Financial leverage: The problem here is that this method of buying with borrowed money doesn't make the investment better or increase the probability of profits; it simply amplifies potential gains or losses and introduces the risk of loss whenever the portfolio fails to meet a contractual value test and creditors can demand their money back at a time when prices and liquidity are depressed.
Over the years, leverage has been associated with high returns as well as spectacular losses and crises. Selling the asset for more than it's worth: Everyone hopes that a buyer will appear willing to pay more for what we have to sell. It's obvious, however, that we can't count on the arrival of a sucker.
On the contrary, having an undervalued asset that reaches its fair value, expecting an asset with a fair price or overpriced to become more valuable requires irrationality on the part of buyers who cannot be trusted. Buying something for less than it's worth: I am convinced that this is what it's all about.
The most reliable way to make money: buying something at a discount relative to its intrinsic value and waiting for the asset's price to move towards its value doesn't require good luck. But rather, market participants need to wake up to the reality that when the market is functioning correctly, value exerts a magnetic attraction on the price of all possible ways to profit from investments.
Buying low is clearly the most reliable; however, this is not synonymous with a guarantee. We can be wrong about the current value, or events can occur that reduce that value, or the deterioration of attitudes or markets can cause assets to be sold below their value, or the convergence between price and intrinsic value can take longer than we have available.
According to John Minard Kees, the market can remain irrational for longer than the investor is able to remain solvent. Trying to buy below value is not infallible, but it is the best chance we have.
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