Value Investing for Mothers-in-Law: Three Psychological Pitfalls to Avoid

By Chris Dudko  MAR 05, 2013 12:23 PM

Remember that value investors, by definition, are buying businesses that are out of favor.

 


My mother-in-law is known to my kids as Doodles. The name’s origin is a long story, but what’s important here is that she is extremely smart and a very capable businesswoman (she doesn’t go by “Doodles” professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.
 
In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.
 
(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
 
Well, Doodles, we’ve discussed which types of businesses are appropriate for long-term investment (What 'Buy and Hold' Really Means) and had some high-level discussion about attractive circumstances under which we might want to buy these businesses (Forget What You Know About 'Margin of Safety'). Now we need to discuss the softer side of things. There are some unique psychological pitfalls that often go hand-in-hand with value investing. In short, you will probably feel like an idiot a lot of the time. Personally, I have years of experience in the field of idiocy and I can tell you that while you might get a bit desensitized to feeling dumb, it is still never easy.
 
Stocks Are Not a Conversation Piece

First, you are going to have to adjust to thinking about investing as something other than a social activity. You’ve probably been to a cocktail party where the conversation eventually turned to the stock market. Somebody probably talked about owning one of the stocks that is forever in the news. Maybe it was Facebook (NASDAQ:FB) and how it might or might not have figured out mobile. Maybe it was JC Penney (NYSE:JCP), which might or might not have ruined itself by dropping and then reinstating its discounting philosophy. Or maybe it was even Herbalife (NYSE:HLF), which may or may not be a complete fraud, depending on which Wall Street titan you want to believe.
 
In all of these cases, nobody is forcing you to own them. Why would you want to fish where everyone else is fishing? If you have some unique insight into one of these stocks, then by all means go for it. Otherwise, doesn’t it seem easier to find a mispricing in a company that most folks have never heard of?
 
Instead, try looking at a business like Graco (NYSE:GGG), which makes machines that squirt stuff (paint, adhesives, lubricants, etc.). Of course, you have to wait until the stock has been pummeled a bit to buy it (i.e. not right now). Can you ever imagine a scenario where someone at a party would want to talk about a fluid dispensing machine business (aside from a party at Graco HQ)? Yet the company is dominant in its niche and will be able to continue pressing that advantage for years to come.
 
Get ready, though, because you are going to be sipping your drink in a corner by yourself when the stock market talk begins.
 
Good Luck Buying at the Bottom, Selling at the Top

Next, you are going to have to get your head around the fact that you are extremely unlikely to buy at the bottom or sell at the top. Remember that when value investing, by definition you are buying a business that is out of favor. Bad earnings reports, cyclical troughs, or splashy scandals (though all with the competitive advantage still intact… very important) can put you in a position to act.
 
Unfortunately, there is little chance that your judgment that the investment is attractive will coincide exactly with the rest of the market changing its opinion in the same direction. Instead, you are probably going to appear to be pretty heavily out of step with other investors.  Someone looking at your portfolio might even wince at all of the supposed “dogs” tying up your capital.
 
It may take a year or more for the market to come around to your way of thinking. Then just as the market starts to really agree with you, the stock is going to hit your target for intrinsic value and you are going to sell it. Again, the market isn’t going to change its opinion exactly when you do. Again, you are going to feel like an idiot as you miss the move from “fairly valued” to “overvalued.” But let’s be honest: How are you going to tell when “overvalued” is “too overvalued”?
 
This happened to me with PetSmart (NASDAQ:PETM). A few years ago, I bought it in the mid $20s, expecting it was worth somewhere in the mid-$40s. The stock lingered for six months or so while the S&P 500 (INDEXSP:.INX) went up more than 20% (I was an idiot). Then the stock more than caught up, hitting my mid-$40s target. I sold (I was a genius). The stock is now in the $60s (I am an idiot).
 
Contrarianism for a Reason, Please

As a fundamental value investor, you will likely be buying businesses that most people don’t care about at a time that, even if they did care about the underlying business a little, they wouldn’t be interested anyway because the near-term looks so hopeless. It can be psychologically hard to feel like you are not part of the club and you will be in danger of becoming a contrarian for contrarianism’s sake. You might dig in your heels and use your portfolio as a means to prove that you are more right than your neighbor. Inappropriate venue, Doodles!
 
To guard against this, your most important weapon is simply being aware that it might happen. Then you are going to have to practice doing your own homework and following pundits a little less often (at the very least, don’t follow them blindly). You are going to have to come up with intrinsic value targets based on conservative scenarios and try to separate your emotions from your stocks. Realize that just by agreeing to play, you are admitting that you are going to be wrong in some way. Embrace your wrongness!
 
Most importantly, when the party conversation turns to stocks, tactfully steer your fellow revelers to the subject of your awesome grandkids.
No positions in stocks mentioned.