Understanding Long-Term/Short-Term and the Optimism/Pessimism Dance in Value Investing

Conundrums. They are all around us.

I was listening to the book Same as Ever by Morgan Housel on the snowy drive back from Toledo OH today. Two things that struck me particularly applicable to value investing, and I wanted to share my thoughts with you on these today.

I wholeheartedly recommend the book, by the way. Also read his Psychology of Money while you are at it. One of these days I will post a review.

Let’s get into these short psychological pushes and pulls we experience every day as value investors.

Long-Term is a Series of Short-Terms

As an investor, you have to be in it for the long-term. You have heard this many times from many people, including me. Does this mean that you and I should just ignore the short-term, close our eyes and wait until the 10 year (or whatever we define the long-term is) is over before we take a look at the portfolio again? Buffett did say that if the stock market closed down for 10 years, it would not bother him a single bit.

On the other hand, what if a company we own suddenly takes a turn for the worst. Are we supposed to just turn a blind eye?

We all understand intuitively what it means to be in it for the long-term, but we fail to do it because the path to the long-term is littered with a series of short-terms that trip us up every step of the way.

Here is my perspective.

I am primarily concerned with the long term as in sticking with my strategy over time. My strategy says: buy undervalued stocks with a good margin of safety. My strategy does not say: buy a stock and do not sell it for 10 years. I will sell a stock next week even if I bought it today if it reaches my target price in one week. If the stock’s fundamentals deteriorate unexpectedly and the risk is too high to continue, I will sell. If the stock does not move for two years, guess what? It is better off in someone else’s portfolio—I will sell.

On the flip side, if a stock reaches our target price and the fundamentals improve more than we anticipated, I will continue to hold if I find that the intrinsic value has now gone up even more.

This is what happens with the quality companies with moats that Buffett keeps buying. Because these companies have a competitive advantage, they keep increasing their market, their share in the market, and their profitability. Their intrinsic value keeps rising, price multiples keep expanding, and Mr. Buffett never needs to sell.

When I run out of profitable small-cap value stocks to buy, as Buffett did many years ago, I will adopt his strategy too. Until then, I buy at a discount, and when the price rises to the fair price and above, I sell.

For example, one of our Premium portfolio holdings has delivered 35%+ in the last six months, with a good chunk of this return coming last week. The company believes that there is another 30% to go before the stock reaches its fair value. This is a higher number than I calculated, but it appears that its latest earnings report indicates that a revisit to my estimate is in order. So, very likely, my estimate of when to sell will move further out into the future.

Short-term tactics can serve long-term strategies

If you are a Premium member, you know that my portfolio allocation changes over time as the stocks in the portfolio rise or fall. Stocks that get closer to their intrinsic value (either because the price rose or the intrinsic value fell) get trimmed, while stocks that get further away from their intrinsic value (either because the price fell or intrinsic value rose) get increased. This recalculation in allocation causes some stocks to be sold and others to be bought.

In other cases, I will rebalance a portfolio even if the allocations did not change, if the stock values drift significantly from the target allocation.

Either of these tactics are reactions to short-term price movements. But they are consistent with my long-term strategy of buying at a discount and keeping a growth-optimal portfolio allocation at all times.

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The Optimism/Pessimism Dance

This one is quite simple once you get it but could be vexing if you have not experienced this yourself.

As investors, we have to be optimists in the long term. A lot of scary things may happen in the short term. Heck, a lot of scary things can happen that last two, four, or even fifteen years. The point is that we know we will come out on the other end and will see our portfolios enhanced if we just stick it out.

But how do we know this?

We don’t know the risks that are out there. All we can do is minimize the effects these risks will have on our portfolios. And the reason we have to do all we can to minimize these risks is that we know that many of these scary things WILL happen this year or next. It’s just the nature of the markets.

Economies go through boom-and-bust cycles. Governments change. Companies—and sometimes whole industries—disappear and are replaced with new ones. There can be wars. There can be technological advancements that completely change the way we live and work.

You may like: How to Manage Emotions When Markets Decline: A Value Investor’s Guide to Staying Rational in Chaos

The way we minimize unknowable risk in our portfolio is by

1. Insisting on significant margin of safety so if something we didn’t expect happens, we have a cushion.

2. Diversify among uncorrelated and weakly correlated assets, so asset risk can be isolated.

3. Use intelligent capital allocation to eliminate the risk of permanent capital loss.

4. As Founder’s Club members know, diversify among different strategies, some of which focus on generating substantial, immediate and growing cash flow income.

In short, while we expect our portfolios to do well in the long-term, we know this will only happen if we are fanatical about removing risk.

Ultimately, long-term success in value investing is about two things: knowing that short-term setbacks are inevitable and structuring your portfolio to withstand them. If you remove the downside, all you have left over is the upside.