James Montier’s The Seven Immutable Laws of Investing
September 19, 2011 1 Comment
James Montier expounds The Seven Immutable Laws of Investing to help investors avoid some of the worst mistakes, which, when made, tend to lead them down the path of the permanent impairment of capital.They are as follows:
1. Always Insist on a Margin of Safety
Valuation is the closest thing to the law of gravity in ﬁnance .It is the primary determinant of long-term returns. The objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety.This reﬂects that any estimate of fair value is just that: an estimate, not a precise ﬁgure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate this law by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.
2. This Time Is Never Different
Sir John Templeton deﬁned “this time is different” as the four most dangerous words in investment. Whenever you hear talk of a new era, you should behave as Circe instructed Ulysses to when he and his crew approached the Sirens: have a friend tie you to a mast.
3. Be Patient and Wait for the Fat Pitch
Patience is integral to any value-based approach on many levels. As Ben Graham wrote, “Under valuations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inﬂated prices caused by over-enthusiasm or artiﬁcial stimulants’ However, patience is in rare supply. As Keynes noted long ago,“Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuations of what they hold, and on capital appreciation… and too little on immediate yield … and intrinsic worth.” If we replace Keynes’s “quarterly” and “monthly” with “daily” and “minute-by-minute,” then we have today’s world. Patience is also required when investors are faced with an unappealing opportunity set. Many investors suffer from an “action bias” – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch.
4. Be Contrarian
Keynes also said that “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive.” Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive.However, humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.
5. Risk Is the Permanent Loss of Capital, Never a Number
The obsession with the quantiﬁcation of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single ﬁgure. The permanent impairment of capital can arise from three sources: 1) valuation risk – you pay too much for an asset; 2) fundamental risk – there are underlying problems with the asset that you are buying (aka value traps); and 3) ﬁnancing risk – leverage. By concentrating on these aspects of risk, can avoid the permanent impairment of their capital.
6. Be Leery of Leverage
Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital. Financial innovation is more often than not just thinly veiled leverage.As J.K. Galbraith put it, “The world of ﬁnance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Whenever you see a ﬁnancial product or strategy with its foundations in leverage, your ﬁrst reaction should be skepticism, not delight.
7. Never Invest in Something You Don’t Understand
This is just good old, plain common sense. If something seems too good to be true, it probably is. The ﬁnancial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it.