Improving On Buffett And Desert Cat

[David Sklansky]

In another thread Desert Cat wrote:

"The real challenges of value investing are

1) Intrinsic Value is always an estimate or even an estimated range and its accuracy depends upon the predictibilty of the investment and your skill and experience.
2) You need to buy at a substantial discount to that IV estimate, your margin of safety, to protect against mistakes.

The biggest problem most attempted practitioners have is a lack of fortitude, patience and ignorance of there own limitations. If you think you can buy at a 10% discount because your IV estimates are always within 5%, you are guilty of hubris and will pay dearly. You need to have the patience to wait, even when awash in cash, for those 50% discounts. And when you find one, you have to have the fortitude to commit a big part of your portfolio to it.

Buffett demonstrates awareness of his own limitations when he refuses to look at a stocks price before he estimates its value, he doesnt want to influence his analysis. That is probably a weakness of mine, I sometimes find a set of assumptions that justify buying at todays price to see if I'm comfortable with them, i.e. XYZ is a buy if I believe its merger is at least 85% likely. Thats backwards, I should make my best estimate of the merger happening and the figure what price makes sense."


Pure thought tells me there is probably a better way. Better that is than merely searching for stocks whose price is half of what you think it is worth. Obviously I might be wrong since I am coming to these conclusions without research. More importantly is the problem that my method, nor Desert Cat's for that matter is of any use unless your expertise is at least sometimes better than the market in general.

Desert Cat didn't make clear in his post whether Buffett requires of himself a stock price fully one half of his own valuation before he buys. He also didn't say whether Buffett, after coming up with his valuation (without knowing the price) adjusts that valuation AFTER seeing the price. Surely he should, even though he would still probably profit without doing that, as long as he mainly stuck to big companies.

I mean as good as Buffett it, I'd bet anything that when his valuations differ from the price by a large amount the eventual results, on average do not come close to his valuations. If they did he would be a quadrillionaire. In other words, no matter how good you are, if your opinion differs markedly from the present price, the true valuation is almost certainly somewhere between those two prices. And probably closer to the market price.

In spite of all that, if you stick to big stocks that have little chance of unknowing shenanigans, and you are good, and you don't pull the trigger unless there is a large discrepancey, you ought to make money. But I think I have a better method for the real experts. (A method closely akin to something I wrote about in GBOI regarding horse racing.)
In theory, this method takes into account not only the stuff Desert Cat talks about, but also aspects of human nature, human stupidity, and human dishonesty, that technical analysis claims to deal with. To pull it off you have to know what Desert Cat knows plus more. But if my idea is right it makes for bigger profits. Not only because your picks should have a greater edge (given equal discrepencies between your opinion and the markets). But also because you don't need as big a discrepancy to buy or sell short.

The idea is to first do as Buffett does. Come up with what you think is the right price for the security without knowing that price. But then come up with a second number. Which is your guess as to what the price actually is. When these two estimates are close you should be very wary of making a play, regardless of the actual price. If you think a stock is worth 50 and you think the market will make it 50, don't buy it a 40 or short it at 60.

If, on the other hand your evaluation of a stock's worth is significantly different from your guess as to what the market price is, you have a play if you are about right about the market price. My gut feeling is that the best situation occurs when the actual price is shaded slightly toward you own valuation. In other words if you think a stock is worth 20 and you think the public will price it at 29, I would feel best about shorting it if it is about 27. Its an indication that some rich, smart people might be agreeing with me.

All this of course is related to my Fundamental Theorem Of Investing. Don't invest unless you can explain why people are taking the other side. In fact using that Theorem you can theoretically beat the market without having expertise on the other end of the spectrum. The experts here hate that technique since it results in trades that ignore their abilities. So forget that for now. Combine them both.

Of course combining them might not be that easy for MBA types. They are used to making good estimates as to what a stock is worth. They are not used to estimating what other people are estimating what it is worth. But if you have that first talent, I would be very surprised if learning that second talent doesn't signifacantly improve your results.