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The business of value investing – Six essential elements to buying companies like Warren Buffett- Charlie Tian 2009
https://bbs.pinggu.org/thread-695143-1-1.html (Page 82-82)
Avoid using margin and focus on absolute result
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As a value investor, your goal is to participate in investment opportunities where the probability of a gain exceeds the probability of loss by the widest possible margins. You devote serious time to analyzing the business, assessing the quality of management, and rationalizing what the business will look like into the future. These efforts require time and painstaking effort. In short, the goal of value investors is to skew the odds very heavily in their favor toward the number - one goal: preservation of capital. This mentality often is referred to as focusing on the downside while letting the upside take care of itself. Margin, or the use of borrowed money, takes all of these goals and renders them useless. For that reason, most value investors avoid the use of margin like the plague. To put it simply, using margin in an investment fund is much like using debt in a business. Although there are important differences, this much is certain: Too much debt can cripple, if not kill, your business. Another critical reason to avoid the use of margin is that it places the destiny of your investment returns in the hands of your broker or banker. And the only time you will ever get a margin call is not when your securities are up in value but when they have declined and your broker demands that you sell your investments to raise cash. Finally, more people should consider the cost of margin. Once you invest using margin, your returns are now influenced by the interest rate charged on that borrowed amount. It seems rather silly to participate in a transaction where the disadvantages clearly outweigh the advantages. And that’s exactly the kind of bet you make when you decide to use margin. Margin essentially involves you agreeing to sell securities at even lower prices and better valuations. Instead of buying more of a business at a cheaper price, margin can force to you sell perfectly sound businesses at fire - sale prices. The financial crisis that came to a head in 2008 illustrates the destructive nature of an overdose of borrowed money. Some of most respected names in finance and banking — Lehman Brothers, Washington Mutual, and Wachovia — have either collapsed or have been chopped up and sold off because they couldn’t restrain themselves from binging on leverage.
When you have a good year, margin works as it amplifies returns, but it has the same effect on losses when performance is negative or even flat. However, what you don’t see from the numbers is the added disadvantages when your performance is negative. As your portfolio holdings decline, your broker will require you to sell holdings to raise cash in order to protect the $ 500,000 loan. You have no choice but to sell or to somehow raise additional outside capital. Most often, the only option is to sell investments, thereby risking the chance that you are selling a security that was initially bought at an undervalued price at an even lower and more attractive price. Making matters worse, should the same security later have a price rebound, your lack of capital prevents you from participating from the upside. All in all, the juiced losses coupled with the loss of control when using margin far outweigh the benefits of juiced returns. The key to successful stock market investing is being able to stay in the game for many years. Avoiding margin is a big step in avoiding a complete wipe out. Buffett said it best when he remarked, “If you depend on borrowed money, you have to worry about what the world thinks of you every day.”
Value investing focuses on analyzing businesses and committing capital to those opportunities that are the most compelling. It should come as no surprise then that the focus for value investors is and should always be absolute returns. An absolute return philosophy is one that has consistent profitability as its key objective. You may be reading this wondering, don’t all investment advisors and investment managers desire to consistently deliver profitable returns? While the clear answer is yes, the goal of most investment professionals suggests no. This is not because they don’t want to generate profits but instead because the vast majority of the investment industry focuses on relative returns. A relative return approach accepts the notion that markets are risky in the short term but believes that, in the long term, investors will benefit from the general growth in the economy.
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In certain time the market can be very volatile and even for great business can drop to below 50% of the fair price. The relative return approach focuses its efforts on allocating capital across various asset classes and industries. The ultimate effect is a broad portfolio that comes very close to mirroring the general stock market indexes. The vast diversification of the relative portfolio will greatly reduce volatility, which has the effect of creating returns that broadly mimic those of the overall stock market. Relative return investors accept these market - matching returns because the majority of individuals will be reporting the same or similar returns. You won’t lose your job if you deliver a negative 15 percent in a year when the stock market declines by 12 percent. Economist John Maynard Keynes said it best when he remarked, “Worldly wisdom teaches that it is far better for the reputation to fail conventionally than to succeed unconventionally.” The name of the game in investment management is to, first, keep your job and then, second, attract additional amounts of capital. To Wall Street, money managers are only as good as their latest year’s results. If 80 percent of active money managers all report declines in the same year, you can’t single one out for being less skilful. It’s far easier to hide among the masses than to stick out your neck and risk getting it chopped off. Unlike the relative return approach, an absolute return approach aims to profit consistently regardless of market return. It should be clear then that absolute return investing relies more on the investor’s skill to produce profits. Further, and as I mentioned earlier, an absolute return approach is obviously much more valuable during bear market periods. Bull markets can make the most novice of investors seem brilliant; it ’ s not until the times get tough that you separate skill from luck. Most important, however, is the understanding that investment records start becoming meaningful after a period of years, not just one year. In the short run, a relative return approach can look extremely good during bear markets. Because value often is found in the most unloved industries, a concentrated value - oriented portfolio could easily find itself vastly under-performing the broad market during a bear market. Remember that in the short run, the market votes, and often those votes don’t favor temporarily depressed businesses. Value investors are by default oriented toward an absolute return approach. Rather than looking at the market as whole, they focus attention on individual businesses. Rather than invest in general asset classes, value investors invest in securities one by one, attempting to find those opportunities that have been temporarily tossed out by the market don’t needing to invested at all times, if the valuations are not attractive, value investors just keep the money and make no investment.
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