What you can learn from Warren Buffett (and Hyman Roth)
“This is the business we’ve chosen! I didn’t ask who gave the order, because it had nothing to do with business!“ – Hyman Roth, The Godfather, Part II
In a brave new investing world that’s dominated by quants who worship at the altar of price momentum, our business has to some degree lost its moorings – and the overall market mechanism is somewhere between wobbly and broken.
But trading and investing opportunities emerge with greater frequency thanks to this change. Volatility and extreme and often-random moves become more commonplace, as the machines and algos rule the day. No wonder there’s little memory in the markets from session to session.
As I’ve previously written, the quants play a disproportionate market role, filling the vacuum created by inactivity from individual investors and "plain-vanilla" institutional players. Gamma trading, risk-parity strategies and commodities pools rule the roost and follow price and volatility, but remain agnostic to balance sheets and income statements.
As such, the quants’ strategies all too often exaggerate market and individual stock-price movements both to the upside and downside, even with no change in a company’s fundamentals. Fortunately, this provides great opportunities for courageous fundamental investors who have a well-grounded understanding of intrinsic value.
Warren Buffett’s investment philosophy holds lots of relevance to today’s market and the opportunities that it presents.
As The Oracle has long argued:
Buffett preaches simplicity in investing, once famously saying: "You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ.”
Remember that quants are the tail that wags Wall Street’s dog today, routinely taking both individual stocks and the broad market to levels of overvaluation and undervaluation for relatively brief time periods. But also remember this other famous Buffett maxim: “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”
My approach is to take advantage of volatility and sharp valuation changes that aren’t coupled with any change in fundamentals or intrinsic value.
Buffett has also said that “in the short run, the market is a voting machine. But in the long run, it is a weighing machine.” Why not take advantage of overvaluations and undervaluations when the ballot boxes are being stuffed? As Buffett once put it: “You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.”
Another priceless quote from The Oracle expands on the theme of taking a fundamental and contrarian investing approach: “The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
Remember, outside influences like sentiment, quants and black swans often deliver more share-price movement than can be explained by underlying fundamentals.
But also keep in mind what Jim “El Capitan” Cramer recently wrote:
“I am an optimist by nature. You need to be an optimist in order to invest. You need to because you need to have faith that things can be good for a long time or get better than they are now. You have to bet on progress – as I have on discouraging days, or middling days like this one – and that a positive albeit skeptical stance makes you a better investor.”
Let’s look at how to put the above precepts into practice.
First, most players shouldn’t short stocks, as that requires a lot of price discipline under the umbrella of an inherently asymmetric risk-vs.-reward ratio. Instead, most traders and investors should simply pay attention to Buffett and Cramer’s instructive comments above and search for long positions to take.
For example, let’s say that General Motors falls to $29 a share from $36 due to a “flash crash” or other outside market influence rather than any change in fundamentals.
A player who’s influenced more by price than fundamentals or intrinsic value will dislike the downward price trend and avoid or even short GM stock. But those who possess a more optimistic view of General Motors than the consensus does will buy or add to a long position.
Personally, I always attempt to insulate myself and take advantage of the super-contagious emotions that routinely swirl around the market. I view the price fluctuations that Mr. Market consistently provides as opportunities to buy wisely when prices fall sharply and sell wisely when prices rise sharply at times when there’s been no change in a company’s operating results.
It’s for these reasons and others that I’m an anticipatory and opportunistic investor/trader at a time when many others (particularly those who favor technical analysis) prefer to be reaction-oriented.
The way I see it, fundamental analysis gives me a compass to establish a company’s intrinsic value. It also allows me to remain disciplined and take advantage of the price aberrations that habitually arise in the marketplace.
When quants take markets or individual stocks to extremes, I attempt to opportunistically take advantage of that instead of embracing price momentum.
For example, I consider shorting when markets get overbought due to ebullience even as the risk/reward equation worsens, as happened late in October. And I consider going long when the quants leave the market oversold and the risk/reward quotient improves, as we saw in late August and late September.
By no means is my approach foolproof, as assessing fundamentals carries its own risks. Being a successful “anti-quant” requires accurate fundamental analysis. And you also need the cojones to ignore price momentum and an apparent “trend” that often swiftly reverses itself.
At its core, you need to disbelieve the statement: “Price is truth.” Instead, you need to believe that “price is opportunity” during periods of upside or downside distortions (or even outright panic).
That’s why, to paraphrase Hyman Roth in The Godfather: Part II, “This is the investment approach that I’ve chosen!”
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