Last week on Thoughts On Money [TOM] we discussed my friend Mary and how she had been misguided by her former advisor. The lesson learned was that it’s important to know what you own and why you own it. If something smells fishy about the advice you are getting, then trust your intuition and dig in a bit with good questions and a dose of common sense that will no doubt help to confirm that you are on the right path. But not all bad advice is easy to spot.
Our friend Mary was misguided, but this isn’t the only way investors get lost; sometimes they lead themselves astray. What do I mean by this? Well, in Mary’s case, her advisor picked her investments, executed the trades, and created her portfolio. While this portfolio was not suitable, lacked diversification, and truly did not have a coherent strategy. And for every Mary that I come across, there are ten investors doing-it-themselves and making these same mistakes.
There is a common theme connecting these mistakes – people often just ignore valuation. Valuation is the science of measuring what something is worth. This type of analytical work is at the core of investing because the price that you pay for something matters. It matters a lot! Valuation affects your rate of return, it helps you to differentiate good investments vs. bad investments, and it is the primary tool successful investors resource when making an investment decision.
The reason people have so much trouble understanding valuation is that they don’t always know which metrics to look at in order to understand what something is actually worth. The stock market may seem foreign or obscure to some, so they disregard what’s actually important in exchange for what’s familiar. They find comfort in investing in companies with a household name (think social media, online retailers, etc.) or they follow “hot topic” trends that they hear about in the news (e.g., cryptocurrencies or cannabis stocks). They make investment decisions without considering valuation.
Imagine this, what if I came to you with an offer to sell you a house and this is all I told you,
“It is a beautiful house. Spacious and well lit. I think it’d be perfect for you and your family. You’ll love the white picket fence, the red front door, and the peaceful garden in the back. Honestly, you are going to absolutely love it. We’ve had multiple offers on the property, and I know I can get you a really good deal. If you put in an offer today, I think the seller would be willing to let it go for $750,000.”
You would never agree to make this purchase based on only the information provided above. It might’ve been a great narrative, but there are some key details and metrics that you’d want to know. For starters, where is the house? How many bedrooms/bathrooms? Square footage? Schools in the area? Comparable sale prices in the neighborhood? Etc. etc. etc.
This is what valuation is all about. You collect some key data and use that information to create an informed decision about how much something is actually worth. You do all of this before you write the check.
If I were to buy that house, based on that limited description I received, then you’d think I was an absolute lunatic, right? Yet, many of us make the exact same mistake when it comes to investing.
Here’s the tough part, understanding how to value a house is very familiar to us, meaning we know what questions to ask and what to look for. Valuing a stock can be more difficult because reviewing a company’s balance sheet or income statement is a daunting task for most of us. David Bahnsen made a recent appearance on Bloomberg, and I loved this quote from him, “Markets are always and forever – this never changes – discounting mechanisms. Their pricing in today what they believe about tomorrow.” And what is the primary metric of tomorrow that markets are intending to discount to today? Earnings. Investors are looking for a return-on-investment (ROI), and that return comes in the form of profits (earnings).
The scariest thing is when investors divorce their investment decisions from this ROI reality. Buying decisions become more about a narrative and hope than about math. In the short run, this may work, but it will most often lead to a destructive outcome. An investor will get a couple wins under their belt and begin to mistake luck for skill. It will be this false sense of confidence that will lead to bigger wagers and more detrimental losses.
I’ll end with this priceless little quip. In recounting an interaction with Warren Buffett, Jeff Bezos (CEO of Amazon) said, “[I asked Warren,] your investment thesis is so simple…you’re the second richest guy in the world, and it’s so simple. Why doesn’t everyone just copy you?” and Buffett responded, “Because nobody wants to get rich slow.”