Friday, March 25, 2011

Immutable Laws of Investing

In August of 2000, Fortune magazine published "10 Stocks To Last The Decade". The stocks on that list were as follows:

-Nokia (NOK)
-Nortel
-Enron
-Oracle (ORCL)
-Broadcom (BRCM)
-Viacom (VIA-B)
-Univision
-Schwab (SCHW)
-Morgan Stanley (MS)
-Genentech

The average price to earnings ratio of these ten stocks at the time?

347x.

Not surprisingly, $ 100 dollars invested equally in these stocks back then ended up being worth $ 30 a decade later.

The excerpt below is from a recent paper, The Seven Immutable Laws of Investing written by James Montier of GMO. In the paper, Montier uses the above as an example of violating Law 1 which is:

1. Always Insist on a Margin of Safety

Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, 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 Law 1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. I've been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000.
Check out the paper to get a good look at the chart. According to Montier, the Seven Immutable Laws are as follows:

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don't understand

The paper goes on to elaborate on each law. Not new material necessarily for value investors but this paper does a nice job of summarizing the tendencies that get investors in trouble from time to time.

Adam

No position in stocks mentioned

Montier's Paper: The Seven Immutable Laws of Investing
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