I was reading a recent article by Bloomberg news about Todd Combs, Warren Buffett’s new right-hand man on stock picking. The article illustrates how Combs consistently buys when prices fall. This buy-low/sell-high strategy is the counter-strategy of riding winners/paring losers which I’ve seen recommended by many traders, behavioral economists, technicians, and statisticians. So where is the truth? Like most disputed questions, the answer lies somewhere in between. Technicians, traders, and statisticians cite the fact that stocks that are down have a better than average chance of going down more and that the market probably knows something that you do not. Behavioral economists cite our tendency for loss aversion which causes humans to hold onto losers too long because of the aversion to realizing those losses and our tendency to sell winners too early because of a desire to “lock-in” profit. The problem with these arguments is that they ignore the crux of any rational investment decision. Specifically, they should simply ask, “What is the value of the company? “
As can be seen in Todd Combs’ strategy (which just so happens to be the philosophy of Buffett as well), a true sense of business value is the driver of buy and sell decisions. When a stock price falls, all else being equal, the risk-reward has become more favorable. When the stock rises, the risk-reward becomes less favorable. This reason alone should be the driving force behind buy and sell decisions for those who actually fundamentally research companies and stocks. Clearly, if the stock is down, the market could be signaling something that the analyst has missed. It serves as a notice to question one’s research, to find the devil’s advocate. But after doing so, if the analyst finds that the facts have not changed, then the improved risk-reward created by a lower price gives the value investor an opportunity that other investors are willing to let slip by.
So what makes the value investor so special? Due diligence. Investors that lack the in-depth research required to understand the company, its financials, and its valuation are subject to the pressures of the market because they do not have the anchor of their conviction. Investors that do not have a calculated potential downside risk and a calculated potential reward, do not have the triggers that allow them to buy and sell with confidence. While clearly, these price objectives are only subjective estimates, they are rooted in concrete research and serve as the critical focal point in any conversation about buying and selling. So, if we want to answer the “To Buy or To Sell” question, the first question an investor must ask is “what is this thing I’m buying or selling worth?” Even though most investors do ask this question, very few actually answer it with a number. Doesn’t that seem odd?