Financial Reference

In the long run, markets are driven by fundamentals. In the short run, markets are driven by fear and greed.

The mere mention of emotion conjures up an image of an amateur. But, more often than not, it’s the professionals succumbing to fear. The fear of losing money, of losing clients, and of losing their jobs.

The professionals job is to try to outperform, but at the very least, to not lose clients. The job becomes “don’t make any huge bets that could make you underperform substantially.” This incentive and the emotionally baggage associated with thought of losing ones job for substantial underperformance leads to emotional decision making.

For example, in Fortune’s Investor’s Guide 2008, the experts wear their fear on their sleeve. One expert, Susan Byrne, is quoted saying, “Think in terms of being willing to lose opportunity instead of capital. Losing opportunity can be embarrassing, but losing capital is permanent.”

But, as any Economics 101 student will tell you, losses are losses whether they are due to a decline in market value or due to foregone profit. The only thing that rationally matters is what expected return for what risk. Trying to limit losses after the bubble has popped is more an emotional response than an analytical response. The professionals limiting their risk today are just compounding their mistake. It goes without saying, that when emotions drive decisions, the wrong decisions are often made.

Value investing is all about recognizing long-term value. It is more important to know timeless investing principles instead of short-term technical trends.

Therefore, much of what you need to know to be a value investor can be gleaned from books. Many of the important books on the list below were written well before current trends in the marketplace. However, the books are timely as when they were originally written.

One Up on Wall Street, Peter Lynch (Invest in what you know)

The Essays of Warren Buffett (Timeless Advice from the master himself; you can also access the entire letters to shareholders here)

Fooled By Randomness (more about risk, but a very good book)

The Warren Buffett Way (always good to learn more about the Man)

Common Stocks and Uncommon Profits (The original growth investment classic; growth is a component of the value equation)

You Can Be a Stock Market Genius (Horrible title, good book)

Value Investing from Graham to Buffett and Beyond (good intro to the basic idea of value investing)

Contrarian Investing Strategies (Data showing value investing works)

I hope you enjoy these books as much as I did when I first read them.

So you want to be a value investor? The first thing you should do is avoid short-term based thinking. This means avoiding the excitement of the markets daily fluctuations, emotional discussion board posts, and “research” based on technical analysis and short-term trends.

Value investors concentrate on the long-term, so it makes sense to use your time reading about long-term strategies. In addition to keeping up with industry news, I encourage you to learn about value investing by prioritizing your reading as follows:

1. Books
2. Magazines
3. Newspapers
4. Blogs/Websites
5. Analyst research

It may surprise you that I hold outside research in such low esteem. I do this for two reasons: (1) analyst expectations are usually baked into the share price and offer no unique information and (2) analysts are very concerned with the short-term view — value is only a component of the recommendation.

In the coming posts, I will recommend specific items within each category to read.

If you read financial news, it’s easy to compare markets to one another. All you need to do is compare price to earnings, price to cash flow, and price to book. Using these ratios, articles can be written determining the relative attractiveness of investing in different markets.

In fact the “Heard on the Street” column on Friday compares these ratios between Japan, the U.S, the U.K., and the world and comes to the conclusion that Japan is relatively cheap. While their conclusions may be correct, their analysis is overly simplistic.

I am not an expert by any means in international accounting or Japanese securities but what I do know was not even addressed in the article. First, international accounting differences affect the income statement, cash flow statement, and balance sheet. This will change the “normal” P/E, P/CF, and P/B ratios across countries.

Second, Japanese companies have significant cross ownership. This means that earnings and cash flow will likely be higher than reported, raising expected P/E and P/CF ratios. Any analyses should at least acknowledge the shortcomings inherent in ratio comparisons across industries, let alone countries.