Focus on the quality, and not the share price, writes The Motley Fool
Amidst these heady atmosphere of risk-on/ risk-off and see-sawing markets, I present you with two famous quotes:
"If you can keep your head when all around you are losing theirs…"- Rudyard Kipling
"If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy." – Warren Buffett
Keep your head
The practice of value investing is simple. The core of this practice requires rational thought and logical thinking. But this is where most investors fail. They fall victim to their own psychological tendencies at precisely the wrong time.
For example, buy decisions on reasonably priced shares are postponed in the hopes that share prices will keep falling. This is logically no different from holding on to an overpriced share in the hope that the share will keep rising. The same illogical thinking even leads investors to selling reasonably priced shares in the hope of buying them back at cheaper prices.
This practice of "predicting" market prices does not work. An investor will never catch a share at its lowest price other than by sheer luck. It is only in hindsight that we can determine that a share has reached a low point.
Once a share has passed its low point, investors are usually not willing to buy, because they are now anchored to the lowest price, and feel they have missed a bargain. Again, this is illogical thinking because it is premised on an assumption that the investor could have predetermined the lowest price.
Focus on quality, forget timing
Let me give you an example.
On 23 July 2008, litigation funder IMF Australia (ASX: IMF) had a share price of 68 cents, yet the company had over 57 cents in cash per share. With over 28 court cases in the pipeline, buying was a no-brainer decision. Over the next 3 years, IMF's share price never saw 68 cents again.
An investor who held out buying in anticipation of the GFC would have missed this. So much for predicting share price directions.
Charlie Munger once said:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
This is easily demonstrated, and we do not need 40 years to prove it. Just 10 years will do.
Good vs bad
Take biopharmaceutical giant CSL (ASX: CSL), for example. At the end of 2002, CSL shares hit an all time high (at that time) of around $16.60 (split-adjusted price). Ten years later, today CSL is selling at $27.80. (We are not counting the dividends you have picked up over the last 10 years). Over these 10 years, CSL's return on capital averages 14.3% per annum, and consequently, profits have grown from $123m in 2002 to $940m in 2011.
On the other hand, even if you have been able to buy Qantas (ASX: QAN) at any one of its lowest points during the last ten years, you will still be down despite brilliant market timing. Over these 10 years, Qantas' return on capital averages 6.2% per annum, and profits have shrunk from $428m in 2002 to $250 m in 2011.
Here is where it blows your mind: in 2002, it does not take a rocket scientist to figure out that CSL is a better business than Qantas. The simple exercise of buying a better quality business, even at all time high prices, was enough to get decent returns.
The easier way to make money
We are not saying that no one can make money timing the market and predicting share prices. We merely believe that purchasing shares in high quality businesses at good prices is an easier way to make money. We prefer the easy life.
If you choose to enter the world of market timing, share predictions and fast paced quantitative trading, bear in mind your competitors in this game: hedge funds, researchers with PhDs, trading desks of giant banks, smart computer programs able to execute in milliseconds simultaneously in markets across the globe, and more. Who is the patsy at the table in this game?
The Foolish bottom line
In value investing, when preparation meets opportunity, an investor who acts decisively will get a handsome return. An investor who fails to act decisively when opportunities present themselves, and instead opts for price prediction and market timing, becomes the patsy at the poker table.
Keeping your head is vital to your investing success. Don't be a patsy.
Are you looking for an easier way to make money? You might want to check out The Motley Fool's free report titled 2 Safe Ways To Play The Commodity Boom. Click here now to request your free copy.
Fool contributor Peter Phan owns shares in IMF, his last purchase being in June 2008. The Motley Fool's disclosure policy is no patsy. This article has been authorised by Bruce Jackson.
