How Schizophrenic is Mr. Market?

I remember that as a kid, I wanted to go to medical school (and that is still true today). Today, I have a patient by the name of Mr. Market. He is more than 70 years old, and was brought in by Mr. Investor as he has suspected signs of schizophrenia. I shall now go through with you what I realized about Mr. Market.

Recently, there was some panic in the Malaysian stock market, with a lot of uncertainties going on there. Many investors are having a hard time stabilizing their emotions and are in a rush to either get in or get out of the stock. Share prices have fluctuated like mad (which is one of the signs for the diagnosis) and many investors got panicky (which was why Mr. Investor brought Mr. Market to me for the clinic appointment).

Not being a specialist in market psychology and psychiatry, I decided to write a letter of referral for Mr. Market to one of the best doctors in this field. Let’s look at what Uncle Warren has to say about this:

quote-mr-market-is-kind-of-a-drunken-psycho-some-days-he-gets-very-enthused-some-days-he-gets-warren-buffett-113-85-82

warren-buffett-quotes-02

Like Uncle Warren, I would prefer to go for a “buy-and-hold” approach compared to a “buy-and-sell” approach. If I pay slightly higher prices today for an awesome company due to their high quality, I’m better off than paying a low price for a mediocre company. This is for a simple reason that the growth of the company will eventually make today’s price look undervalued. Let me make a hypothetical scenario out of this:

Screen Shot 2018-06-02 at 9.32.33 am

So as we can see, the “price” I pay per dollar of earnings is $4.83 for Company A and $1.10 for Company B. However, because I know that Company A has a much stronger quality compared to Company B (as seen from the ROE), I will say that Company A is more undervalued compared to Company B. As such, I will go for Company A even though I have to pay a higher price.

Beautiful theory, but how do I put it into practice? The approach goes like this:

  1. Set a limit to the number of companies you are going to invest in. Uncle Warren has a “20 ticket punch card” approach, where once he invests in a company, he will “punch” a hole in the card. He will not invest once all the punch card is full.
  2. Start analyzing businesses using the various metrics you have for such companies. Do note that different companies and industries require different valuation methodology, so do apply the correct one to the correct companies (e.g. don’t value a e-commerce company using price-to-book ratio because that simply doesn’t make sense). Also, it is key to ensure that your metric is justifiable (don’t use the metric simply because you make it look undervalued just to convince yourself to buy the stock – that is a big symptom of self-denial).
  3. When the share price comes down to a point it is within your valuation, you can start accumulating. Or if you like, you can be like me in the US market where I sell put options to start the process of accumulation (but have the mindset that it is already exercised once the order is filled) at an even better price. Always remember, market timing is completely irrelevant here.
  4. Keep looking for quality companies and repeat step 2, even after your punch card is filled. When we encounter a company that has a better quality compared to the company that is of the worst quality in our portfolio, replace the one originally in your portfolio to this new company. I usually use a sell call option on the former and a sell put option on the latter to do so. This way, we keep improving the quality of our portfolio as we select them. I like to rank my portfolio from 1 to 8 (my punch card has a total of 12 slots).

In electronics, we always talk about something known as the signal-to-noise (S/N) ratio. Before I used this approach, I realized that there is so much chatter in the coffee shops about some stocks and that literally creates more noise. By using this methodology, we increase the S/N ratio for our portfolio as we distill out the best companies we have found so far. All we need to do is to compare the worst guys in our portfolio to the potential candidate trying to come on board. It’s now a single combat, much easier to judge compared to the Warring States.

As our portfolio quality gets better over time, we will also be improving the process as we learn to be stricter in our selection. Remember, you are the buyer not the seller. You have the right of choice of the companies (and partners) you bring on board. This allows us to cut down on unnecessary trades, or selling when the price seems high. As Mr. Hemant Amin said, “the only cost in investment is opportunity cost.” Indeed, it is the case in both the public market and the private equity sector (which I deal with from time to time). If the whole objective behind selling a good quality company is to bag cash, then there is simply no point of taking action.

Let’s take a look at some insights from Kenneth J. Marshall (KM) when he accepted an interview with Safal Niveshak (SN), one of the top financial blogs I have read of all time:

dont-sell-e1527878496807

Hope this helps you in your process of distilling out the crème de la crème when you invest. Ciao! 🙂

I hereby diagnose Mr. Market with severe schizophrenia.

This blog post is done based on a reflection of my friend, Xin Er from Learnvestor.

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