Editor’s note: This article was first published in July 2013. The Google share prices ($900 versus $200) are pre-split 2013 figures, and the remarks on Facebook, Twitter, LinkedIn and Groupon reflect 2013.
In 2011, James Montier, seen as a provocative critic of today’s investment methods, set out the 7 immutable laws or principles of investing: the ones that worked in the past, work today and will always work. His simple investing laws are nothing out of this world, but applying them can let any individual investor beat the returns of the big funds.
Montier starts from the premise that most of the investment decisions we make are not rational, which is why we buy at the top and sell at the bottom. Following the herd is what leads us to watch our money shrink instead of grow. His principles, unsurprisingly, overlap with many of the investing rules used by Benjamin Graham, although, unlike Buffett and Graham with their investment horizon (holding shares forever), Montier believes that there is nothing you can buy and hold forever.
1. Insist on a margin of safety
We understand that valuing companies is complicated for individual investors, so Montier, like Graham, stresses the importance of investing with a margin of safety. That doesn’t mean valuing the company so you can buy it at its fair price, but investing with enough of a cushion to absorb possible mistakes in your estimate of that fair price.
The margin of safety is not only found in the valuation of a company, but also in the moment you buy into it. You are more likely to make money investing in a company that is just starting out and has a lot of potential than in one that has performed well over the last decade and is now seeing its price punished. For example: buying Google at $900 gives us no margin of safety. That doesn’t mean Google won’t keep rising, but buying the shares at that price would keep us up at night. On the other hand, having bought Google at around $200 would have meant getting in with an excellent margin of safety. In short: look for the next Google.
See also: Facebook’s IPO: its business model and risk factors
A margin of safety means buying shares and still being able to sleep soundly at night. Don’t look for a company that has posted double-digit growth for 10 years. Look for a company that is going to grow exponentially over the next 10 years. Of course, sometimes there are companies that have grown for more than 50 years and will almost certainly keep growing for the next 10 or 20. That is why Buffett invests in Coca-Cola.
2. This time is not different
This is an interesting point, because these are the words that have always got us into trouble. Whenever there is a “boom” in something, whether construction or tech companies, people tend to think that this time will be different, that the business models are new and the outlook has changed. Reading between the lines, what Montier is basically saying is that most of the new tech companies will blow up sooner or later because of their high valuations.
It’s true that there are many tech companies, such as eBay, Amazon, Google and Apple, whose businesses may be more sustainable over time, but be careful with many others, such as Facebook, Twitter, LinkedIn or Groupon, since we don’t know what users will want five years from now. Are we sure the social network of the future has already been invented?
3. Be patient
The most profitable approach is to find a company the market undervalues and wait for the market to recognise its potential. That takes patience, and patience is something most investors lack, as they are increasingly caught up in the culture of the quick win.
4. Do the opposite
Given statistics showing that more than 70% of short-term traders lose money in the stock market, Keynes used to say: “The fundamental principle of investing is to go against the general opinion, because if everyone agrees on buying a share that gets every recommendation, you will inevitably buy it expensive, and so it is unattractive.”
As I have said more than once, and this is something I can personally vouch for, the best time to buy a share is not when people advise you to buy it, but when they advise against it. Thanks to this, we often find excellent margins of safety when buying a stock.
5. Risk is the permanent loss of capital, not a number
P/E, VaR, beta, standard deviation… Weighing up all these factors to try to work out how much risk we are taking on in an investment is, without a doubt, an unnecessary complication. As I understand Montier, the permanent impairment of an investment only comes from 3 sources:
- Valuation risk, where we pay too much for a share.
- Fundamental risk, where we buy a stock that has underlying problems, either in its market or because the company has manipulated its accounts. These are known as “value traps”.
- Financing risk: leverage, excessive debt… Be careful about investing in heavily indebted companies, as it is getting harder and harder for them to refinance their debts at reasonable cost.
6. Be wary of the rules of the game
Leverage is a dangerous beast. It can never turn a bad investment into a good one, but it can turn a good investment into a bad one. Montier says that when you are offered a leveraged investment product, your first reaction should be distrust.
On this point I don’t entirely agree. It’s true that when we have a large fortune, we should avoid leverage almost entirely. When we have some money, leverage should be kept to a low percentage. And when we don’t have a single euro in our pocket but we do have knowledge, leverage is practically mandatory if we want to grow our capital.
That said, it’s true that most leveraged products are rotten from the start, designed by their issuers to take retail “players'” money. Always remember that most leveraged products are zero-sum, which means you lose because someone else wins and you win because someone else loses. In these games the big players almost always win, which, by simple common sense, means the odds will always be against you.
7. Never invest in something you don’t understand
This principle or law of investing is 100% common sense. Don’t invest in an investment product you don’t understand, don’t invest in a stock you don’t understand, and certainly don’t go into the stock market if you don’t know at least the basics. Investing in unfamiliar products just because someone recommended them, or buying shares in companies we know nothing about, are two of the things that cause the most losses in the markets.
Further reading
- Bernard Madoff: no one succeeds on Wall Street without cheating
- 3 investment ideas that can get you into trouble
Featured image: Print made by: William Hogarth Published by: Mrs Chilcot Published by: Richard Caldwell, Public domain, via Wikimedia Commons.
.jpg){kind=link}