Value Investor

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Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers, on the whole, occupy, underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.

Human capital

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What’s human capital?
To start, we need a definition. Here’s what Wikipedia has to say: “Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.” A little tricky, but basically human capital is the economic value of a person based on their skills and ability in the workplace.

So who gets paid for human capital?
In a free-market economy, everyone gets paid based on their own human capital. We each own our own skills and abilities and we collect income based on our ability and value when we work. Regardless of whether we work for a company or ourselves, we’re compensated for the value we’re able to provide.

So far so good. Now let’s tie this into investing. Without some understanding of the market, people tend to believe that they can beat the market by picking the right stocks. Consistent success (beating the market) in stock picking is actually impossible, but let’s pretend for a moment that’s not. If the market was beatable, there would naturally be people who were especially endowed with the skills and/or training to beat it. Those people would often become money managers and they would be highly sought after by the general public looking for great returns in their portfolios. But who would collect the premiums for additional returns achieved above-market returns? Stock picking would be a human capitalist skill! The brilliantly skilled money manager would collect some serious fees for his valuable ability, fees almost exactly in line with the amount of return he was able to achieve above the market. The additional return of the portfolio wouldn’t end up in the pockets of investors, it would go to the brilliant manager with the impressive human capital skills.

So here’s the point: the stock market is efficient and so it’s not consistently beatable, but even if it was, investors would not be the beneficiaries. The super-skilled money managers would rightly collect large fees, highly correlated to the additional value they were able to provide based on their human capital skills.

Can investing be stress-free? (Part 1)

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Yes! But there are some requirements:

Requirement 1: an understanding of the market.

Stress-free investing involves an understanding of the market. Not an understanding of what the market will do in the next 10 minutes, or next 10 days, or next 10 months, that would require psychic abilities which is unfortunately unrealistic, but a real understanding of how the market works and what you can and should expect from the market.

Two main points here:

  • The market is unpredictable. Prices already reflect all of the knowable information, the market moves based on future information. Since no one knows the future no one knows how the market will move in the future, despite what some financial professionals may have you believe. The misnomer that you or the professional you’re working with must have some insight into the future movements of the market is the cause of a lot of stress by itself. Thankfully, stress-free investing doesn’t require clairvoyance.
  • The market is volatile but it trends upward. The volatility makes the market feel dangerous. People generally believe that they could lose most or all of their money in a market downturn (talk about stressful!). But the truth is that markets trend upwards, and over long periods of time (10+ years) the market is always up, despite whatever crashes it may have endured (including the Great Depression and the 2008 housing crash). If you’re invested well (which we’ll get to in part 2), you don’t have to worry about the market destroying your savings! You just have to ride out the dips and enjoy the long-term, upward trend. The market is only dangerous if you try to bet and predict it, it becomes your friend when you focus on owning it.

Open options

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It’s 2019. The industrial revolution began over 200 years ago. Political democracy was ratified almost 250 years ago. Capitalism began its ascent somewhere around 500 years ago. In 2019 the world is a much different place and changing at a much more rapid pace than ever before. The rise of technology, the commitment to political freedom, and the resilience of free markets have resulted in remarkable life improvements. We have more free time, we understand the concept of a vacation, we even live longer. But maybe the most impressive change in the last 500 years is the incredible increase in the number of options we have. We’ve got multiples of ketchup options at the grocery store, we’ve got multiples of grocery store options within driving distance, we’ve got endless options for entertainment built right into our TVs, we’ve got so many bars and restaurant options we can’t keep track of where we’ve been and where we’d still like to visit (just me?), we’ve got innumerable product options staring at us from our phone screens, we’ve got travel options, vacation options, gym options, school options, cell phone options, clothes options, housing options, the list goes on. The sheer volume of options seems a little crazy when you think about it, but we love all our options. Options are great, they’re an essential part of freedom, they give us the ability to direct our lives to a degree. For most of history people didn’t have many options. As far as work went, the option was to essentially do what your parents did (which was probably farm). Now we’ve got thousands of career options, and that’s a wonderful thing.
The flipside of all these options is the requirement to make lots of choices. Options are great, choices are work. They’re work because you have to sift through all of the options, but more so because you eventually have to make a decision. The word ‘decision’ comes from the Latin root ‘decidere’ which literally means ‘to cut off from.’ Making a decision involves choosing one option instead of a bunch of other options, it means cutting off the other options, it means giving up the other options. So that’s a problem, what if we really liked having all those options? Options equal freedom!
The real problem with our abundance of options is that it gives us the illusion of freedom but it’s often crippling. We begin to idolize our options to the exclusion of making decisions, to the exclusion of making progress. We become content to maintain the beautiful platter of options without ever making a commitment to any. I suspect that this is especially true in our work. I love to vacillate on different strategies for my business, different side-hustles I could start, different events I could host. I love to ‘keep my options open’ so to speak. But in the end, that’s just wasted time. You could spend your entire life keeping your options open and never accomplish anything. The fear is that once you commit something you’ve got to be all in and you’ve got to say ‘no’ to the other options, but the alternative is to live a life of waffling waste filled with eternally open options. That’s definitely worse. So make a decision!