Investment Iron Law X: Mastering the Tools of Stock Market Offense and Defense#
Buy when Value is higher than Price. Sell when Value is lower than Price.
Value Investing#
The strategy of “buy any stock, buy at any time, and don’t sell” sounds simple, but most people can’t follow it. Even if they acknowledge its potential for wealth creation, they lack the courage to implement it because it seems to contradict common investment beliefs and principles. Therefore, the author presents three superior investment strategies: value investing, growth investing, and contrarian investing. Before investing, using these strategies, you must ask yourself: Does the investment target hold this value? What is its future growth potential? Is everyone investing in it? These three investment strategies can help you make better decisions.
Verifying Value Ensures Profitability
During the 1920s, Florida’s real estate prices skyrocketed daily, triggering a buying frenzy. One fortunate investor managed to secure a plot of land. Most buyers didn’t care about the land’s quality, but this investor prudently asked a real estate agent to show him the purchased land. He was shocked to discover it was swampland. “Can anyone live here?” he exclaimed. The agent calmly replied, “Why worry about that? As long as the price goes up.”
“Human behavior and decision-making are perfectly rational” is a fundamental assumption in academic research and theoretical development. Generally, consumers won’t rush to buy unless a product offers exceptional value. For instance, no one would pay $5 million for a car worth $500,000 unless they were foolish. Investment decisions, involving money and future wealth, are even more critical than buying a car. Logically, people should be more rational and cautious, making decisions only after careful calculations.
However, are investors truly rational? In July 1985, China Development Corporation’s stock price was NT$14 per share. Four years later, in September 1989, it reached NT$1075, a nearly 80-fold increase. Remarkably, in 1985, when the price was low, investors shunned the stock, resulting in low trading volume. Conversely, in 1989, when the price soared to over NT$1000, investors rushed in, fearing they would miss out, driving trading volume to its peak.
Are these investment behaviors rational? Consider the difference between China Development Corporation at NT$14 in 1985, at over NT$1000 in 1989, or even at NT$50 in 1983. Essentially, the difference was minimal; it was the same company, managed by practically the same people, with similar assets. Why such a drastic price difference? The answer lies not in the company’s intrinsic changes but in investors’ behavioral and decision-making biases.
Between 1989 and 1990, during the Taiwan stock market’s peak, investors continued pouring in. The author often asked friends and family, “Do you think the stocks you’re buying are worth the price?” Most found the question perplexing and avoided answering. Some reluctantly admitted, “Probably not.” The author would then ask, “Why buy them then?” Their confident reply: “They’ll go up!”
Some also questioned the author’s lack of participation in this lucrative market. The response: “I’ll wait until after 4000 points to invest.” The author believed the Taiwan stock market’s true value was below 4000 points (in 1989). Those who heard this scoffed, “Keep waiting.” As it turned out, overvalued assets cannot rise indefinitely. In August 1990, the Taiwan stock index plummeted to around 2000 points, proving the author’s point. No investment’s price can remain perpetually above or below its true value.
Buy When Value Exceeds Price
Value investing, introduced by Benjamin Graham in his 1933 book Security Analysis, was later championed by his students, including Warren Buffett and John Templeton. In the 1980s, value investing gained prominence in the US, becoming the strategy of choice for many successful long-term investors.
Value investing posits that every stock has an intrinsic value. Price fluctuations arise from investor trading. Prices exceeding intrinsic value will eventually revert, and prices falling below will eventually recover.
The principle is simple: buy when the value is higher than the price, regardless of market fluctuations. If it’s cheap, buy it. Conversely, sell when the value is lower than the price. In short, buy low, sell high. Sell when prices significantly exceed value amidst widespread buying, minimizing holdings. Buy when prices fall drastically below value amidst widespread fear, increasing holdings.
Typically, investors focus solely on price appreciation, neglecting value. People meticulously research cars, refrigerators, or stereos for months, comparing models, reading reviews, and seeking advice, constantly evaluating value for money. They’ll wait for a sale if the price is too high. Yet, when buying stocks, often on a whim based on a tip or hearsay, they overlook value, making hasty decisions involving sums far exceeding appliance purchases.
Invest with an Owner’s Mindset
Warren Buffett’s investment philosophy emphasizes investing with an owner’s mindset and a long-term perspective. This involves buying stocks of companies with stable earnings growth, positive prospects, high asset value, or simply when the intrinsic value exceeds the price.
Crowds flock to department stores during sales and clearances. The steeper the discounts, the larger the crowds. Conversely, shopping is most pleasant when there are no sales, as stores are less crowded. This is because consumers are motivated by value, buying when prices are below perceived worth.
However, in stock markets, the opposite occurs. Brokerage houses are deserted when stock prices are at their lowest. Conversely, they are packed when prices are soaring. Investors are motivated by rising prices. A stock falling from $100 to $50 attracts little interest, while rapid price increases fuel buying frenzy.
The assumption of rational economic behavior applies well to consumer choices but not to investment behavior. As illustrated, investment decisions are often driven by irrational emotions, impulses, and intuition.
Value investing advises emulating consumer behavior: buy when stocks are “on sale,” and avoid the herd when prices are inflated.
Developing the Ability to Calculate Asset and Earnings Value
The key to successful value investing is the ability to calculate a company’s intrinsic value, encompassing asset value and earnings value. Asset value represents the liquidation value of the company’s assets per share. Earnings value represents the present value of the company’s projected future earnings. Estimating future earnings is challenging, requiring the development of forecasting skills.
Calculating intrinsic value is not easy. Investing in familiar companies simplifies this process. Taiwanese businesswoman Shirley Wang, CEO of FIC Global, primarily invested in FIC and related IT and semiconductor companies. Her familiarity with the industry allowed her to better grasp its dynamics.
Many successful investors adhere to Buffett’s philosophy, investing only in familiar companies. Li-Ching Hsu, former Taiwan head of ING Group, frequently advised investors to focus on companies in their own industry or related sectors.
Investment decisions should always involve value analysis. Buy when the value is present or the price is attractive; sell otherwise. Value investing encourages adopting consumer-like behavior in the stock market, buying low and selling high.
1. When investing in stocks, ask “Is it worth buying?” not just “Will it go up?”
2. Learn from consumer behavior: buy when prices are discounted.
Choose a great company, and if it keeps growing, you’ll almost never have to sell.
Growth Investing#
Valuing a company is challenging. Some professional investors therefore focus on earnings growth rate, a primary driver of value, as their investment criterion. Growth investing has been successfully employed by renowned investors, notably Peter Lynch, former manager of Fidelity’s Magellan Fund, who achieved the highest 15-year return among hundreds of US mutual funds.
Investing in High-Growth Potential Stocks
Simply put, growth investing involves buying stocks of companies with high future growth potential and selling when that potential diminishes. A key characteristic is maintaining full investment, ideally diversified. Growth investors acknowledge their inability to predict short-term market movements but believe in the long-term upward trend of stocks, especially those with high growth potential.
They invest all their capital in high-growth stocks. Peter Lynch maintained a nearly 100% invested portfolio during his tenure at Magellan Fund, keeping minimal cash reserves for redemptions.
The key to successful growth investing lies in identifying companies with high growth potential. This is the challenge: finding high-growth stocks. Investing in IBM 30 years ago, Microsoft 15 years ago, or Cathay Life Insurance in Taiwan would have yielded multifold returns.
However, countless seemingly high-growth companies fizzle out. No one can predict the future with certainty. Even Peter Lynch admitted that only half of his stock picks were truly successful, but that was enough. Therefore, diversification is crucial for mitigating the higher risks of growth investing.
Growth investing believes that a company’s real growth drives stock price appreciation. Investment returns depend on the earnings over the next few years. For high returns, choose investments with 5-10 year growth potential. Invest in companies in high-growth industries with excellent performance and a sustainable growth outlook. Their stock prices are likely to rise with the company’s growth, offering substantial long-term gains.
Choosing the Right Industry is More Important Than Choosing the Right Company
Growth investors prioritize future earnings growth potential. Industry growth is crucial for a company’s earnings. Choosing the right industry is therefore more important than choosing the right company. Consider the future 5-10 year demand for the company’s products, focusing on the industry’s growth potential. Peter Lynch advised against selling good stocks prematurely for small profits and recommended selling stocks of companies with deteriorating growth prospects, even at a loss. This approach allows gains from successful picks to offset losses from unsuccessful ones, resulting in overall profit.
Peter Lynch advocated for a “common sense” approach to investing, illustrated in his book One Up On Wall Street. He profited from observing his wife’s preference for certain hosiery and dish soap brands, and his children’s preference for certain sneakers, leading him to invest in those companies. This approach can be explained by market efficiency theory. Retailers and observant consumers are often the first to notice a product’s popularity, before analysts. By adopting a consumer perspective and noticing trends overlooked by experts, investors can gain an edge.
In early 1996, after a frugal, retired court clerk passed away, her family discovered her substantial wealth. She had consistently invested small amounts in Coca-Cola stock for decades, capitalizing on its growth and share price appreciation. This illustrates the power of long-term investment in growing companies.
Don’t Just Focus on Price Fluctuations
Many investors are unclear about their investment rationale. If you can’t explain your investment’s business and growth potential in five minutes, you shouldn’t own it. Focus on monitoring the validity of your investment thesis, not daily price fluctuations.
Many investors prefer startups or pre-IPO companies. However, established, profitable companies with growth potential are often better investments. Peter Lynch suggested capturing the middle five years of a company’s 15-year growth trajectory, rather than the initial or mature phases. If a stock has the potential to rise from $2 to $200, wait until it reaches $8 before buying. The potential gains are still substantial, and the risk is lower. Losing money in the stock market is quick, but making money takes time. Most stocks take 3-5 years to rise significantly.
Regarding industry growth potential, in Taiwan, IT, communications, and semiconductors within the electronics industry are promising. Pharmaceuticals and biotechnology are also attractive due to increasing health consciousness. Taiwan’s ten emerging industries (specialty chemicals, environmental protection, aerospace, telecommunications, semiconductors, IT, pharmaceuticals, precision machinery, etc.) offer future growth opportunities. In the service sector, securities and investment trust, construction, and shipping also have good prospects. Savvy investors should anticipate future trends, popular products, internet-driven products, and leverage their own consumer insights to identify investment opportunities.
Growth investing is suitable for non-professional investors. It requires no specialized training or constant monitoring. To identify growth stocks, consider a company’s potential performance over the next 5-10 years. Invest in companies with strong growth potential and hold them long-term, selling only when they transition from growth to maturity. This strategy allows even amateur investors with limited time and expertise to achieve good results.
1. Real earnings growth drives stock price appreciation.
2. Diversify investments in companies with sustainable 5-10 year growth potential, patiently awaiting substantial returns.
Don’t follow the crowd; be rational. Figure out what most people are doing, then don’t do it.
Contrarian Investing#
Many ask, “Is there a better time to buy than ‘any time’?” Research suggests there is: contrarian investing, a time-tested and remarkably effective strategy.
Buy Straw Hats in Winter, Boats in a Drought
A 19th-century American tycoon, when asked about his wealth-building secret, replied, “Buy straw hats in winter.” Similarly, Fan Li, a wealthy merchant in ancient China, followed the principle of “buying fur coats in summer, selling in winter; buying boats in a drought, selling when it rains.” These are examples of contrarian investing.
This investment concept originated in ancient China. According to Records of the Grand Historian, Ji Ran, an economist during the Warring States period, proposed the contrarian strategy of “invest in boats during drought, invest in carts during floods.” He argued that during droughts, when everyone invests in cart production, one should invest in boats. The oversupply of carts would lower prices and profits. When the rains return, boat demand would surge, raising prices and profits. Conversely, during floods, when everyone invests in boats, one should invest in carts.
Contrarian investing means investing when most people aren’t and selling when everyone is eager to buy. The concept is simple: go against the crowd. However, implementing it is challenging. It requires overcoming human nature, resisting herd mentality, cultivating independent judgment, and enduring loneliness. Most investors follow the crowd, while contrarian investors look for opportunities when others are fearful. This strategy relies on the belief that widespread consensus is often wrong and that reversals can be powerful.
Don’t Be Deceived by Net Buying or Selling
Contrarian investing works because when most people are bullish, available capital is already invested, leading to overinflated prices. With everyone already in the market, poised to sell, potential supply outweighs demand. Any negative news can trigger a sharp decline.
Conversely, when most people are bearish, selling pressure is minimal as most have already sold. With potential buyers waiting on the sidelines, demand outweighs supply. Any positive news can trigger a sharp rise.
Investors tend to extrapolate past trends, especially when reinforced by market sentiment. During initial market declines, most see it as temporary, while a few predict further declines. As the market continues falling, bears are rewarded, and bulls suffer. At severely oversold levels, widespread pessimism creates buying opportunities. Conversely, during initial market rallies, most see it as temporary, while a few predict further gains. As the market continues rising, bulls are rewarded, and bears suffer. At severely overbought levels, widespread optimism leads to overvaluation.
Bullish When Rising, Bearish When Falling
People tend to become more optimistic during optimistic periods and more pessimistic during pessimistic periods. They rely on memory to predict the future. A rising market breeds bullishness, and a falling market breeds bearishness.
At the peak of the Taiwan stock market in late 1989, the author taught an investment course. During one lecture, a student requested the author refrain from discussing stocks. Surprised, the author asked why. The student explained that every class, from political science to calculus, included discussions about stocks.
Another anecdote from that period involves a professor asking his class the time. A student instinctively replied, “9865 points, up 65 points.” Students were constantly monitoring stock prices during lectures. This illustrates the pervasive stock market mania at the time. As it turned out, this widespread obsession was a harbinger of the impending crash.
Great investments often involve defying conventional wisdom, selling when others are buying, and buying when others are selling. Be bearish before others when everyone is bullish, and be bullish before others when everyone is bearish. As a Wall Street adage goes, “Markets are born in despair, grow in skepticism, mature in optimism, and die in euphoria.”
Contrarian investing doesn’t require constantly opposing the majority. It encourages resisting herd mentality and cultivating independent thinking. The best buying opportunities may arise when most are afraid to buy, but buying solely for that reason is as foolish as following the crowd. The crowd isn’t always wrong. Develop independent judgment. True contrarians don’t blindly oppose the majority but wait for the dust to settle and buy when no one is paying attention.
Contrarian investing applies to stock selection. David Dreman, in his book Contrarian Investment Strategies, argued that unpopular companies often outperform expectations, while popular companies are susceptible to minor setbacks.
Timing the market is difficult. Mastering the principles of contrarian investing can be highly rewarding.
1. Invest when others aren’t; sell when everyone is eager to invest.
2. Don’t follow the crowd; buy when investor sentiment has cooled and no one is paying attention.
Value, Growth, and Contrarian Strategies are Best Suited for Experts
These seemingly disparate strategies are not mutually exclusive. Investors can choose or combine strategies based on their individual characteristics. The most effective strategy is subjective and depends on individual circumstances. The author recommends value investing for those skilled in financial analysis, growth investing for those with foresight, and contrarian investing for independent, emotionally disciplined individuals.
Value investing is considered the most sophisticated technique, requiring strong financial knowledge and valuation skills. Most investors lack this expertise. Even among analysts, few truly understand valuation. Growth investing requires foresight to identify high-growth industries and companies, which is also challenging. Contrarian investing requires no specialized knowledge but is the hardest to implement due to its counterintuitive nature. Most people are trend followers. Few can buy when everyone is selling or sell when everyone is buying.
These three strategies can enhance returns if mastered and applied correctly. Countless self-proclaimed “investment experts” populate the market, but few consistently outperform using these strategies. Misapplied, these strategies can lead to short-term speculation and losses. Therefore, the author still recommends the simple, yet effective, long-term buy-and-hold strategy of “buy any stock, buy at any time, and don’t sell” for most investors.