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Two investing theories you must know

Mar 3, 2011

Life and investing. What makes each day, and each trade different is that you don't know what will happen tomorrow. The unpredictable, the unexpected, it makes life worth living.

The same goes with investing. What makes it interesting is the fact that you don't know exactly what is going to happen in the next trade, forget the next day. It depends completely on the future, which is unknown. Hosni Mubarak held office for 30 years in Egypt. Gaddafi, the Libyan leader is one of the longest serving rulers of all time, holding office for over 40 years. Who would have predicted that 2011 would be the year that these leaders would be taken down, shaking global politics, the oil trade and sending shockwaves through world markets.

The beauty of investing lies in the fact that everyone is trying to find out how to make the most out of an unknown future. Well, what follows in this article are two basic approaches to help make sensible investing decisions. These two theories have been put forth by Burton Malkiel, a famous American economist and writer. He has authored the bestselling book entitled - 'A Random Walk down Wall Street'.

These two theories have been used by seasoned investors across the globe. And the best part is that they seem to be mutually exclusive. They are absolutely a must know for anyone interested in investing.

The Firm-Foundation Theory

This theory assumes that any financial instrument, be it stocks, options, real estate etc. has an intrinsic value. For a company's stock, this value is determined by the firm's current situation and its future prospects. This value serves as an anchor. If valuations deviate from this foundation, a buying or a selling opportunity is created. The theory assumes that this deviation will be eventually corrected. Over time, the stock will revert to its intrinsic value. By investing, one is basically playing on the difference between the actual price, and its true worth.

John Burr Williams (1938) was one of the first few economists to view stock prices based on this theory. He propounded that rather than focusing on forecasting stock prices, an investor should instead focus on estimating future corporate earnings and dividends. These future cash flows can be discounted to the present date to find the intrinsic value of a stock. After all, one buys a stock for its future earnings potential. Benjamin Graham and David Dodd wrote about this theory in their book 'Security Analysis'. Life and investing. What makes each day, and each trade different is that you don't know what will happen tomorrow. The unpredictable, the unexpected, it makes life worth living.

The same goes with investing. What makes it interesting is the fact that you don't know exactly what is going to happen in the next trade, forget the next day. It depends completely on the future, which is unknown. Hosni Mubarak held office for 30 years in Egypt. Gaddafi, the Libyan leader is one of the longest serving rulers of all time, holding office for over 40 years. Who would have predicted that 2011 would be the year that these leaders would be taken down, shaking global politics, the oil trade and sending shockwaves through world markets.

The beauty of investing lies in the fact that everyone is trying to find out how to make the most out of an unknown future. Well, what follows in this article are two basic approaches to help make sensible investing decisions. These two theories have been put forth by Burton Malkiel, a famous American economist and writer. He has authored the bestselling book entitled - 'A Random Walk down Wall Street'.

These two theories have been used by seasoned investors across the globe. And the best part is that they seem to be mutually exclusive. They are absolutely a must know for anyone interested in investing.

The Firm-Foundation Theory

This theory assumes that any financial instrument, be it stocks, options, real estate etc. has an intrinsic value. For a company's stock, this value is determined by the firm's current situation and its future prospects. This value serves as an anchor. If valuations deviate from this foundation, a buying or a selling opportunity is created. The theory assumes that this deviation will be eventually corrected. Over time, the stock will revert to its intrinsic value. By investing, one is basically playing on the difference between the actual price, and its true worth.

John Burr Williams (1938) was one of the first few economists to view stock prices based on this theory. He propounded that rather than focusing on forecasting stock prices, an investor should instead focus on estimating future corporate earnings and dividends. These future cash flows can be discounted to the present date to find the intrinsic value of a stock. After all, one buys a stock for its future earnings potential. Benjamin Graham and David Dodd wrote about this theory in their book 'Security Analysis'. Warren Buffet is probably one of the greatest practitioners. Buffet would buy stocks when they were well below their intrinsic value, and then sell them when they became expensive. He has famously said that his favorite holding period is forever. He would try and invest in companies which had a solid moat around them, and are still running strong such as Wells Fargo, Johnson and Johnson etc. This method is also known as value investing.

However, the tricky part of this theory lies in estimating the rate at which these cash flows will grow, and the length of time they will continue. Analysts do not always have similar views on the same depending on their perception of an uncertain future. Buffet also famously stated that he and Charlie Munger might come up with different answers if asked to calculate the intrinsic value of a stock.

The Castle-in-the-Air Theory

An opposing theory is the Castle-in-the-Air theory. While the firm-foundation theory appeals to the thinker in us. This theory appeals to our emotional, jealous, fearful and greedy side. The side that wants a better car than what your neighbor has. Or the latest smart phone. As you can now tell, this theory concentrates on psychological values and the behavior of a group of investors. John Maynard Keynes set forth this theory, as early as 1936. And despite huge technological advances, the emotional side of man has stayed on the same levels. In Keynes opinion, professional investors prefer not to estimate intrinsic values. But rather determine how a group of investors is likely to behave in the future. During periods of optimism, these investors would build their hopes like 'castles-in-the-air'. We saw this phenomenon in play during the 2008 market rally. This theory also led to the 'subprime crisis' where buyers were relying on housing prices to keep rising. But, they ultimately crashed. We continue to see investors do the same on a day to day basis as well. This is also called momentum investing. A momentum investor would look at buying rapidly rising stocks, and selling them later during their 'uptrend'. Technical analysts tend to look at the charts in order to find such stocks which might have a breakthrough.

According to Keynes, the firm-foundation was too much work, and needed a lot of analysis, which may be doubtful. Human nature on the other hand was predictable. One just needed to make the right bet. He successfully practiced what he preached, making a lot of money for himself and his college endowment fund. Keynes said that "it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20, three months hence". Ultimately, an investment is worth a certain price only because you can sell it off at an even higher price.

To be a successful investor in this situation one would need to get in before the crowd does. And one needs to analyze what situations are more susceptible to 'castle building' by the investing public. To go with the old adage, 'the early bird catches the worm'. A sucker is born every minute - according to Malkiel. It is OK to buy something that is 3 times its intrinsic value, only if you can find someone else to buy it at 5 times the value.

Create your own strategy

We believe that investors who understand both these theories, and apply them successful can be successful. The intrinsic value and the Warren Buffet philosophy is the ideal way of investing. Undeniably, it is hard work and involves a lot of reading, analysis and waiting for the right opportunity. And if you do find a wonderful company at a fair price, rather than a fair company at a wonderful price, you are really in luck.

But, you may not always get an opportunity to buy below intrinsic value. During IPOs, the buyer is usually the sucker, as the sellers look to exit only at the highest valuation. Lots of investors made a lot of money during the 'tech bubble' when there was mass euphoria for all such stocks. But, they all came crashing down when the bubble ultimately burst. Investors, who understood momentum trends, were able to profit from the same. It is easy to follow a crowd, but being the first one in, and not being the last one out is the real test. You need a mix and match these strategies in order to profit on your investments. But remember that, markets are a great leveler.Warren Buffet is probably one of the greatest practitioners. Buffet would buy stocks when they were well below their intrinsic value, and then sell them when they became expensive. He has famously said that his favorite holding period is forever. He would try and invest in companies which had a solid moat around them, and are still running strong such as Wells Fargo, Johnson and Johnson etc. This method is also known as value investing.

However, the tricky part of this theory lies in estimating the rate at which these cash flows will grow, and the length of time they will continue. Analysts do not always have similar views on the same depending on their perception of an uncertain future. Buffet also famously stated that he and Charlie Munger might come up with different answers if asked to calculate the intrinsic value of a stock.

The Castle-in-the-Air Theory

An opposing theory is the Castle-in-the-Air theory. While the firm-foundation theory appeals to the thinker in us. This theory appeals to our emotional, jealous, fearful and greedy side. The side that wants a better car than what your neighbor has. Or the latest smart phone. As you can now tell, this theory concentrates on psychological values and the behavior of a group of investors. John Maynard Keynes set forth this theory, as early as 1936. And despite huge technological advances, the emotional side of man has stayed on the same levels. In Keynes opinion, professional investors prefer not to estimate intrinsic values. But rather determine how a group of investors is likely to behave in the future. During periods of optimism, these investors would build their hopes like 'castles-in-the-air'. We saw this phenomenon in play during the 2008 market rally. This theory also led to the 'subprime crisis' where buyers were relying on housing prices to keep rising. But, they ultimately crashed. We continue to see investors do the same on a day to day basis as well. This is also called momentum investing. A momentum investor would look at buying rapidly rising stocks, and selling them later during their 'uptrend'. Technical analysts tend to look at the charts in order to find such stocks which might have a breakthrough.

According to Keynes, the firm-foundation was too much work, and needed a lot of analysis, which may be doubtful. Human nature on the other hand was predictable. One just needed to make the right bet. He successfully practiced what he preached, making a lot of money for himself and his college endowment fund. Keynes said that "it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20, three months hence". Ultimately, an investment is worth a certain price only because you can sell it off at an even higher price.

To be a successful investor in this situation one would need to get in before the crowd does. And one needs to analyze what situations are more susceptible to 'castle building' by the investing public. To go with the old adage, 'the early bird catches the worm'. A sucker is born every minute - according to Malkiel. It is OK to buy something that is 3 times its intrinsic value, only if you can find someone else to buy it at 5 times the value.

Create your own strategy

We believe that investors who understand both these theories, and apply them successful can be successful. The intrinsic value and the Warren Buffet philosophy is the ideal way of investing. Undeniably, it is hard work and involves a lot of reading, analysis and waiting for the right opportunity. And if you do find a wonderful company at a fair price, rather than a fair company at a wonderful price, you are really in luck.

But, you may not always get an opportunity to buy below intrinsic value. During IPOs, the buyer is usually the sucker, as the sellers look to exit only at the highest valuation. Lots of investors made a lot of money during the 'tech bubble' when there was mass euphoria for all such stocks. But, they all came crashing down when the bubble ultimately burst. Investors, who understood momentum trends, were able to profit from the same. It is easy to follow a crowd, but being the first one in, and not being the last one out is the real test. You need a mix and match these strategies in order to profit on your investments. But remember that, markets are a great leveler.

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