The Iron Rule of Investing You Must Know | Smart Change: Personal Finance

Sometimes the worst thing you can do when valuing an asset is to pay too much attention to whether you are going up or down. In other words, what you paid for a stock at any given time doesn’t affect its current intrinsic value. In this episode of “The Morning Show” on Motley Fool Live, recorded on December 21Motley Fool analysts John Rotonti and Sanmeet Deo discuss how “pegging” to your past purchase price can keep you from getting the most out of the investment here and now.

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John Rotonti: What do you think, Sanmeet? Focusing on whether you are up or down in a position means that you are anchoring yourself in the past, it distracts from the work of making the best possible decision in the present. Thoughts?

Deo Sanmeet: I think that’s great because what’s going on is you – and I was very guilty of it – you anchor from a price and then that limits whether you’re going to reinvest or how you’re going to proceed. with the position sometimes. And it sits there while you do your analysis on the business, and you just think I’m down 30% or 40%. This stock is not good. This business is not good. Not necessarily. A stock is down 30, 40, 50 percent even. This is the stock; it does not mean that the value of the company is less than 50 percent. It’s possible, but we don’t know until we do the analysis and look ahead and see what it can produce in terms of cash flow and profit. Does he have a strong balance sheet, can he survive, what is going on with the stock that is driving him down? If you get too grounded it’s a matter of state of mind, it really disrupts your state of mind to do unbiased analysis. Because you’re already going there thinking, I hate this business, I’m so depressed. I don’t know why I’m even looking at it, and you research it and you think it’s hard to see why it’s down, and it’s not the analysis. The analysis should be, well, why is it going down, yes. So what can it do in the future, is the market just overreacting? Are the prospects for the future still good? Is there a bump in the road that it hits that I feel it can overtake. It’s like having to turn off your monitors, like your brokerage accounts, when you dive deep into a business that you think you want to buy more of. Don’t look at the stock price, don’t look at your earnings and unrealized gains or losses, and just look at the business.

Rotonti: I agree 100 percent too. I separate this into two buckets. One is for stocks you already own, which is what this iron rule of investing refers to. Because he says focusing on whether you’re up or down in a position means grounding in the past. The other bucket is when I am looking for a whole new business for the first time. It is a company that I do not know and that I do not know. I’m going to go to the ends of the earth trying not to look at the recent history of the stock charts, the price chart. I don’t want to know if the stock has been going down for a year or six months or up for a year or six months, as that will inevitably cloud my judgment. Let me give you an example. I was recently researching a company that I didn’t know about. Now I’m very familiar, just spent a month doing a deep dive. I managed not to look at the stock chart once until I learned all I can about this company from scratch, loving a lot of what I see. I think it deserves an evaluation. I first tried to understand the business, as what I see, to understand the management, as what I see. Then I say, “OK, I’ll try to value this thing. I appreciate it, and I like what I see, therefore everything I like. Then I look at the stock chart after a month of work and see that the stock is going up – I don’t want to give it away – the stock was up over 50 percent last year. More than 50 percent, less than 120 percent, within that range. It’s a lot last year. This little piece of information, that the stock has risen over 50 percent, less than 120 percent in the past 12 months, got me thinking. Because I was like, “Oh, man, did I miss the boat, blah, blah, blah?” After a month of hiding the stock charts from me, hiding the stock price from me. I wanted to value it from scratch with a blank slate, knowing nothing, and I got it right. And then I looked at this stock chart and realized that it had gone up a lot. It had beaten the market significantly over the past 12 months. It gave me a slight pause, then self-control took over and I said, “Damn the stock chart.” If I think its value is attractive no matter what the stock has done, then I will consider buying or recommending it. Then if it falls and the story doesn’t change, I will consider buying more or recommending more. But just spending those three seconds looking at the stock chart gave me a month’s break from research. Then, of course, if it’s something you already own, anchoring is the worst thing you can do. Oh, my base price is $ 20. The stock is now at 70. Why would I buy more? When did I originally have 20? Well, because the business has grown, intrinsic value has increased, earnings and free cash flow have increased. You can’t compare a 20 share price to a rising 70 share price. Three years apart, when that company’s earnings and free cash flow are so much higher three years down the road than they were when you bought at 20 Share prices are inconsistent. You liked the business and decided to buy the business three years ago, its fundamentals were different. Three years later, you plan to buy more. Wrap your head around that, you fools. The stock price may actually be more attractive at 70 than it was at 20. Yes, that is a possibility. You can determine that the stock is trading with a bigger safety margin at 70 than it was at 20. Because intrinsic value may have risen a lot since then. Embedded value may have surprised so much on the upside since then, that maybe management has done something amazing that you didn’t anticipate when you rated it at 20. They maybe did. an incredible acquisition. Maybe they brought in an amazing CEO. Anything could have happened. The stock price might be more attractive at 70 than at 20, because it is not just the stock price of 20 versus the stock price of 70. These are the fundamentals of the business at 20 versus business fundamentals at 70. It is possible that business fundamentals at 70 are much stronger.