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It first discusses the theory and the differences, at a theoretical level, between value investing valuation and the traditional valuation one learns at a finance program at any university and then transitions from theory to practice.
Ben Graham type, as well as Buffett type franchise and growth companies will be analysed and valued in this step. The final step is that of deciding to buy or not, using the concept of Margin of Safety. Portfolio formation and risk management are also discussed in the final step. Endorsements of the book have been written by prominent value investor professionals such as, W.
Browne, L. Cunningham, R. Oldfield, M. Pabrai, B. Robotti, T. Russo, K. Shannon, and A. They will never tremendously underperform. They will always be in the ballpark. When you read studies and books indicating that the average portfolio manager underperforms, it is not difficult to understand why. If, on the other hand, you read more recent studies, which are more carefully done, they do show that narrowly focused funds that invest in stocks tend to outperform.
The further away a fund is from the index, the better it does. In other words, portfolio managers underperform not because they lack stock picking abilities, but rather because institutional factors force them to overdiversify. The incentive system forces them to overdiversify and this leads to their underperformance. There are two forces that drive the premium ascribed to value investing. Both underlying forces are not going away any time soon. That is, humans will continue to be humans and institutional investors will continue to have conflicts - which are very difficult to eliminate.
As a result, if human nature will not change, and the conflicts of interest of portfolio managers will not change, it is reasonable to conclude that the value premium will continue to exist in the future. It is important to understand the weaknesses of human nature, especially as it applies to investing, in order to be able to see these weaknesses in your own behaviour and try to control them or devise strategies to deal with them. The first academics who talked about human nature were psychologist professors.
One of them, Daniel Kahneman, won a Nobel Prize. He used to ask his subjects to play the following game. Most people would choose to toss the coin. This way he demonstrated that humans are not symmetric. When they win, they become risk averse and when they lose, they become risk takers.
Kahneman, through his experiments, demonstrated that humans are not rational. They are not the dispassionate calculating machines that market efficiency assumes they are. And he provided further evidence against market efficiency and the way it is taught at universities around the world. Investors who hold positions in the stock market tend to sell their winners too soon and hold on to their losers for too long. That is, when they are making profits i. On the other hand, if they are experiencing losses, even if the stock has only downside, they stick to holding the stock.
Humans have a short memory span; they remember the recent past. They tend to extrapolate the past naively. They believe that if a stock has been a winner, it will continue to be a winner going forward; the opposite for the losing stocks.
And so, they keep buying the winners and selling the losers. This is what creates the vicissitudes of stock prices. This may seem inconsistent with what I just said under point a - but it is not. This is because point a above refers to stocks you already own, while this section refers to stocks you do not own.
Overconfidence is part of our human DNA. It has been built over millions of years of our evolution. Think of our ancestors, the cavemen, who came out of their cave with a little stick to kill a mammoth. They must have been very overconfident and overoptimistic. Overconfidence allowed them to survive and to mate.
We are overconfident in every aspect of our lives. How is this possible? But when overconfidence comes into our investing, this is bad for our wealth. We tend to become day traders and market timers and it does not work. In fact, there is some academic research which shows that because men are more confident than women, women tend to do better in investing than men. We overreact on the downside; we also overreact on the upside. And the less reliable the source of the information is, the more we overreact.
There were many such stories of overreaction to unreliable information in the late s and early s during the dot-com bubble. Humans see order when there is none. They like shortcuts and devise rules of thumb, which sometimes work by accident, but mostly do not. Humans also interpret accidental success to be the result of skill. They are lucky yet think they are skillful, and so next time, they bet the farm and lose.
Finally, we tend to believe more information that agrees with our views. We tend to think inside the box. Humans change their behaviour in parallel. We are social beings that like to be in groups. As individuals, if we see the crowd go in one direction, we think that the crowd knows something, and we go the same way.
As professionals, we know that no one lost his or her job because of average performance. If we are in a group and the group loses, it is not a big deal. But if we go out on a limb and go on a different direction than the group and we lose, when the group wins, we may lose our jobs. That is why herding is more prevalent in smaller companies, in growth stocks and emerging markets. Analysts also herd. The low ability analysts hide in the group.
The good analysts already made a good name for themselves so why go out on a limb?