When people less familiar with the financial sector ask me about my work and I answer that I’m an analyst in an asset management company and we invest in stocks, I get the impression that they imagine me in a giant room, with people screaming down the phone and a lot of screens full of graphs with prices, like in The Wolf of Wall Street.
I believe that this misconception comes essentially from the fact that not everyone is aware that shares are pieces of companies and shareholders are nothing more than their owners. However, this doesn’t happen only to those who don’t know about finance, it’s something that many investors also forget.
The image projected in films and TV series about stock market investing is much more glamorous than our reality as analysts and managers. In fact, if you ever came to the area where the Cobas Management team works, it looks more like a library than anything else.
As I like to explain to anyone who takes a bit more interest in what we do and is not left with the superficial image, our work is quite similar to studying, in our case listed companies. Because as I said, a share is a stake in the ownership of a company, and for that reason we spend more than 90 percent of our time analysing companies and trying to determine how much they are worth.
In the end, that is what sets us value investors apart: we know the value of things and that enables us to buy companies with a wide margin of safety, which is our main protection against mistakes and unexpected events.
Besides, knowing the value of the companies in which we invest allows us to be disciplined and not get carried away by emotions. The type of investment we make involves, most of the time, going against the market and that is not easy. It is difficult to do something different from what most do, because, by our very nature, human beings want to be part of a community and we are afraid of feeling alone or missing out on something.
In fact, professors and psychologists Naomi Eisenberger and Jeffrey A (1). Lieberman published a very interesting study in 2004 in which, with a computer game, they tried to simulate social exclusion and scanned the brains of the people who participated in the game. They found that the parts of the brain that respond to that exclusion are the same as those that are triggered when we feel physical pain.
A solid valuation framework
What, then, is the best protection against that “pain” that going against the crowd causes us? Without any doubt, the best protection is having a robust investment process and a solid valuation framework. Only in this way, by thoroughly studying the companies in which we invest, knowing their business well and knowing their true value, are we able not to panic when the price of the companies in our portfolio drops and we are even able to increase our position. This is because value and price are not the same thing in the stock market.
An example that illustrates the importance of doing a good valuation and analysis job is what happened recently with one of the companies in our International Portfolio, the British company Dixons Carphone. In the two years that we have been following it, as in any company we analyse, we have read the Annual Reports, numerous industry-specific and company-specific reports, we have built a valuation model with ten years of historical data and we have updated our investment case after each news and earnings reports. And in the specific case of Dixons, we have spoken with more than ten independent experts, including former company employees, executives of companies in the industry, suppliers and analysts, and we have seen the management team (both old and new) on several occasions.
That extensive work and deep knowledge of the company allowed us to stand firm in our convictions after the last earnings release. On June 20, 2019 the company announced that, due to a deterioration in its mobile distribution business, Carphone Warehouse, next year earnings will be worse than expected by the market. That day the share price dropped by 20% first thing in the morning.
The logical thing, for someone who does not know the company well and does not know what it is worth, is to be afraid of the headlines and the drop and make the mistake of selling the shares. Conversely, we know that the mobile business is less than 20% of sales, and despite the worse earnings expected, it is a business that will generate a lot of cash in the coming years.
In addition, the rest of the businesses are performing well, and the company also announced that day that it intends to meet its objectives concerning margin increase and cash generation a year earlier than expected.
After that news, we updated our investment case and concluded that our valuation of Dixons remained intact, which allowed us to make decisions in a cool and rational way, despite the panic in the market.
Today, the share price has already overcome that drop and has in fact risen more than 15% from the lows that it marked during the days after the earnings were released.
Obviously, everything we do is not an exact science and despite doing our homework, we can be wrong. However, doing a good analysis and valuation job is the best way to avoid being guided by our instincts, which is something that is very dangerous when talking about our money.
- (1) Study by Eisenberger and Lieberman: Why rejection hurts: a common neural alarm system for physical and social pain.