When Investing, Sometimes it helps to Think like a Surfer

 “There is a tide in the affairs of men, which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life is bound in shallows and in miseries.
On such a full sea are we now afloat, and we must take the current when it serves,
Or lose our ventures.”

Warren Buffett advises investors to think like owners when investing in stocks.  In other words, approach a potential investment as if you were buying the entire business, not just a piece of paper.  The point is, have conviction before you invest.

That’s good advice.  But I’d like to take that thought one step further.

There’s an important distinction when it comes to investing in stocks vs. private businesses, one that our business schools leave most students unprepared for, namely this: it’s not enough to be right about the business, you need to be right about the stock too..

I’ll explain.  Let’s say you have an opportunity to invest in a private business.  It might be a rental property, a retail store, a restaurant, a tech business, etc.  Presented with these opportunities, the facts you need to consider are all (or mostly) readily available.  You’d review the financial statements (assuming it’s a going concern), analyze the competitive landscape, evaluate management, check on suppliers (if relevant), assess the stability of the customer base, weigh the economic conditions, etc.  Assuming you were properly trained with some basic financial skills, you could make a reasonable estimation of fair value and decide whether the business could be purchased at a price that would allow for a decent profit, even allowing for the business to encounter some speed bumps along the way.  It might be a lengthy process, and the answer as to whether to invest may not always be clear, but the point is you could identify the factors you’d need to consider.

Is it easy?  Not necessarily.  But here’s the welcome news:  if you’re good at this kind of thing and you get the facts right, you’re good to go.  You don’t need your neighbor’s approval, or that of some investment committee, or from any other investor for that matter.  If you buy a good business at a discount, you’ll make a profit.  Buy a rental property below its fair value, you’ll have steady cash flow.  Guaranteed.

That’s not the case necessarily when it comes to investing in publicly-traded stocks.  You could do the most accurate, thorough analysis, but if other investors don’t see the same opportunity as you, your investment will languish.  The solution: expand your horizons.  Look beyond the business factors alone and take the pulse of the market.  It might know more than you do.  It’s not unlike the way a surfer approaches his or her craft.  They don’t expend their energy when the current is against them, or when conditions or too calm.  Rather, they look for that moment when the tide swells toward shore, at just the right moment, and with sufficient energy, to deliver a satisfying ride.  The same holds true with stocks – you need other investors to share your conviction, to provide that favorable swell if you will, for that stock to go higher.

So what’s the missing ingredient when it comes to stock market investing, you might ask?  Academics like to refer to it as “animal spirits”.  Practitioners tend to think of it as “momentum”.  Whatever the label, this is the “soft science” in investing, one that fundamental investors often frown upon, but that is a very real phenomenon.  For all of the talk about “efficient markets,” there is a tide to the ebbs and flows of stocks, aided (or abetted) by the flow of available money from our central banks and the sentiments of other investors.  We’ve only just begun to understand it, and it’s a very imperfect science, but learning to harness the trends of the market, and of individual stocks, can be the difference between a struggling investor and a successful one.

Now, over time, the stock market will almost always reward good analysis.  One does not always have to look for stock momentum (more on this in a separate post).  As Warren Buffett’s mentor Benjamin Graham was fond of saying, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  In other words, in time stock market participants will “weigh” a stock correctly and recognize its full value.  If your analysis is right, you will make a profit.  In the long run, that is.  But the long run can be a very long time indeed, and one must consider the opportunity cost of whether the performance of a long-term investment will exceed or lag that of the market.

So look for opportunities when an undervalued stock is starting to gain some traction, i.e., when other investors are along for the ride, before you invest.  Understanding the power of these trends, these tides, can improve your returns significantly.

Please note: I reserve the right to delete comments that are offensive or off-topic.

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