This article’s headline, a direct quote from Berkshire Hathaway Vice Chairman Charlie Munger, cuts right to the heart of the matter: If you are not investing based on fundamental valuation principles, you are not investing. You may think you are, but Ben Graham had another term for it: speculation.
Intelligent investing defined
As Graham stated in the book Security Analysis:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Graham’s definition implies that a true investment is made only when you have the right data and reasoning, followed by a suitable price that ensures a margin of safety. Putting capital to work any other way is, by its nature, speculative.
Value investors focus not on their performance in a bull market, but on their perseverance during a bear market. In his 1961 partnership letter, Warren Buffett expressed this crucial point when he told his partners, “I would consider a year in which we decline 15% and the [Dow Jones] average 30% to be much superior to a year when both we and the average advanced 20%.” Most investors don’t fully grasp this investing approach, and the result is inferior long-term performance relative to the benchmarks.
Speaking of bear markets, in the 1960s, Buffett invested more than 30% of his assets in one company, American Express, during that company’s worst scandal. While everyone else was running, Buffett stood still, because he was confident in his data and reasoning.
Always remember that price is what you pay and value is what you get. A fantastic business like Google is undervalued at one price, fairly valued at another, and overvalued at yet another. At the current price, investors in Google are sacrificing a margin of safety and betting on the continuance of very high growth rates, which we know simply cannot go on forever. It’s one thing for a company like Google to double profits from $2 billion to $4 billion, but it’s much more difficult to go from $20 billion to $40 billion.
When you bet, bet big
Few words have influenced me more than these:
Truly outstanding investment opportunities occur only occasionally. In general, the better they are, the rarer they are. Such opportunities are normally long-term in their maturation and by careful study can be foreseen long before they come to the attention of most investors. … The very highest profit potentials occur whenever there is a convergence of two or more primary causes.
These sound like homespun words of wisdom from Graham or Buffett, but they aren’t. They come from silver analyst Jerome Smith in his book Silver Profits in the Seventies, more than 30 years ago. Smith was referring to silver, but his words also characterize the qualities of superior investments that true value investors seek to exploit.
Smith is right: Really good investment ideas are rare. So when you find one, bet big. If your thorough analysis is correct and the price is right, you should have no hesitation in investing heavily. One need look no further today than Mohnish Pabrai and the Pabrai Investment Funds. Pabrai currently manages about $600 million or so, up from $1 million in 1999. About 80% of that total is parked in just eight to 10 of Pabrai’s best investment ideas, including Pinnacle Airlines and IPSCO . The result is a 29% net annualized return since inception, meaning that a $100,000 investment back in 1999 is worth almost $800,000 today.
Simply put, if your convictions won’t allow you to put 10% of your assets in one investment, you probably don’t need to have even 1% of your assets invested. But that’s why such obvious investments are so rare, and when your data and reasoning are correct, be sure to take advantage of the opportunity.
Buying good businesses at bargain prices allows the investor to ride out a storm relatively unscathed. But sound investing is not easy. The key is to train yourself to be unemotional about the market and maintain an unwavering level of discipline. History has shown that there will always be periods of prosperity followed by periods of economic contraction. That will never change. If you invest with the aim of keeping your capital, the upside will take care of itself.