Value-investing revisited (Part II)
Value-investing involves investing in assets, which are priced substantially below their intrinsic value. This valuation discount or “margin of safety” serves as a buffer and provides protection against non-achievement of intrinsic value.
This article, (as part of a series) deep-dives into the individual components of value-investing.
Value-investing ignores emotional biases
Typical investors remain susceptible to numerous emotional biases, which lead to judgmental errors and sub-optimal investment decisions. Some of these biases are listed here:
- Herd behaviour- Bubbles are created when investors follow each other blindly without any consideration of sound investment logic. It is caused due to an inherent tendency of human beings to confirm to those around them and a belief in the ‘correctness’ of collective opinion. Value-investors, however, focus only on ‘what they know’ and don’t invest in ‘fashionable’ assets.
- Confirmation- Quite a few investors form an investment decision beforehand and any research that follows is merely to confirm their preconceived notions. Value-investors, on the other hand, believe in conducting an objective analysis of all the important variables before accepting or rejecting their hypothesis.
- Overconfidence- Misguided levels of perceived expertise lead investors to place overconfidence in their judgment leading to an utter disregard for apparent risks. Any success that ensues could only be attributed to sheer luck and is very unlikely to be replicated. However, investors end up getting more confident of their ‘expertise’ and set themselves for an even bigger fall. Value-investors remain cognizant of this fallacy and corroborate their judgment with hard facts wherever possible. Risk is never ignored by them and an adequate margin of safety is a prerequisite for any investment decision. When successful, they acknowledge judgment was one of the tools in their disciplined investment process.
- Overreaction- This is more of a consequence of succumbing to emotional biases. Judgmental errors rarely lead to prudent investment decisions and objective reality eventually catches up with the investors. When market starts discounting any new information, these investors overreact out of panic as hard facts don’t align with their expectations and end up squaring off their investments at the worst possible time. Value-investors rarely get influenced by markets going in the opposite direction vs. their expectations as their decision is always based on sound analysis and they wait for the right valuation before getting out of their investments. In fact, this effect of emotional biases is well recognized by value-investors who recognize overreaction as an anomaly and use it as a profit-making opportunity.
Value-investors invest at a significant discount to the fair value
Typical investors get lured by any amount of profit perceived to be ‘certain’ by them. While doing so, they ignore any element of risk and don’t look at the downside protection. But this behavior is counterintuitive in increasingly efficient markets where such ‘certain’ profits would soon get wiped out and hence, it becomes even more imperative to look at the downside risk. Any resulting profit would invariably remain immaterial and possible losses significant. Value-investors, even when confronted with near-certain profit-opportunity, always keep in mind the possibility of losses and ensure a reasonable buffer of safety in their purchase price.
Arthveda Star, in its pursuit of value-investing principles, steered clear of premium housing in Tier-I cities, which despite being a perennial favorite of investors/ speculators, could head for a hard-landing. It focused on research before deciding on a potential pool of investments so as to avoid confirmation and overconfidence in its expertise. These tenets in addition to building a significant discount during the actual investment would prevent panic-induced overreaction.