By Soo Chuen Tan
Reuters
STAMFORD, Conn. (MarketWatch) — Benjamin Graham wrote that investment is most intelligent when it is most businesslike. Like many other ideas from this great value-stock buyer, this assertion is astoundingly profound in its simplicity.
Let us try to figure out what he meant. Imagine getting a phone call from a CEO you know casually, offering to sell you his publicly traded company at what seems like a low price. What would you say?
In a contest between a hated company and a loved one, bet on the one you don't like. Mark Hulbert joins Markets Hub. Photo: Bloomberg.
A natural reaction would be: Why are you selling? Why am I getting a deal?
The next questions might include: What does the company do? What are its products? How does it make money? Why do consumers buy its products and not that of competitors? Who are its competitors, and how do they behave? Why are there not more competitors?
If the company sells overseas, you’ll want to ask about the countries where it competes. What happens if bad things happen in these countries? Also, how dependent is the company on its suppliers? What happens if consumer tastes change? Can you trust the managers running the company?
If you are satisfied with the answers to these questions, then you can ask about the numbers. For example: How much cash profit does the company generate each year on average? How much in a good year? How much in a bad year? What explains this discrepancy?
Then you’ll want to know how the company does under different economic conditions. If the economy suffers from deflation, can the company hold prices? Can prices rise with inflation?
You’ll then try to justify the purchase price. How long would you need to own the company before you recoup your initial investment? If the business goes under, what can you liquidate, and how much money can you get back? If the business continues to grow, how much capital needs to be plowed back in, and at what rates of return? Is this return better than other uses for your money?
Questions unsaid
What is most interesting are the questions not asked, including:
What is the company’s stock price? Where was the stock trading last year? Where will it trade next month — has it already had its “run”?
Does the stock chart form a “bearish diamond,” and has it fallen through its “support level”? What will be next quarter’s earnings per share, and is this higher or lower than Wall Street consensus? How does the stock’s P/E or PEG ratio compare with its peers, or the market?
What is daily liquidity in the stock? How many analysts have “Buy” recommendations on the stock, how many have “Hold,” and how many have “Sell”? What is the stock’s “beta”? Do the shares “zig” while others “zag”?
You would not have asked these questions because you were thinking like a business person. The decision before you was whether this business was worth buying at the price offered to you. If not, you would thank the CEO politely and keep your cash. This company simply was not cheap enough for you.
Such questions illustrate an important set of rules for value investors. You must maintain investing discipline by reminding yourself of the key principles that underpin our craft:
1. Be greedy when others are fearful
Warren Buffett, in his 1994 Berkshire Hathaway shareholder letter, wrote the following:
“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen,” he said.
“Indeed,” Buffett noted, “we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.” Read more: Warren Buffett's winning ways, 50 years on.
The last sentence of this quote is particularly important given the human tendency to express emotional reactions in analytical terms.
For example, “I want to wait for this stock to trade lower” may simply mean “I am afraid to pull the trigger.” The "equity-risk premium has increased" may simply mean "people are becoming more fearful." "Expected return per unit of volatility of equities has increased" may translate to "people are more bearish about stocks."
To invest based on these “analytical tools” (e.g., discount rates, portfolio weighting and the like) seems more the tail wagging the dog — unless you use these signals as contrarian indicators.
2. Be fearful when others are greedy
Maintaining price discipline is hard to do with record low interest rates around the world.
To use a Texas Hold ’Em analogy, investment strategies that play hands more “loosely” (are more willing to pay up for businesses) are more likely to generate higher short-term marked-to-market returns in an environment like today’s, because continuous money-printing means that “blinds” continue to be raised for all investors, forcing investors to “bet” more.
Nevertheless, value investors who maintain their price discipline are more likely to come out better over a longer term. That’s because “looser” investment strategies implicitly include a component of “catastrophe put option selling.” Those who pay up for a business reduce their margin of safety — the cushion against potential losses caused by unforeseen downside risks, analytical errors, or plain bad luck.
Without this margin of safety, an investor risks sustaining permanent capital impairment if any potential negative scenarios actually occur. Of course, in the meantime, the investor collects a “put option premium,” which may show up as strong interim marked-to-market returns.
3. Volatility is a poor measure of risk
The riskiness of this implicit catastrophe put option (or “cat”-insurance) selling is often under-appreciated. Since long-duration investors infrequently “take money off the table,” the end point is the most important in any geometric return series of an investment strategy. This cat-insurance selling is unlikely to be well-captured by conventional market price-based measures of return-per-unit risk, such as the Sharpe Ratio.
More generally, it seems quite counterintuitive that “risk” is widely measured using observed market price movements. Just as the best time to sell any cat-insurance is right after that cat-event, the best time to “underwrite” a downside scenario for a company is when that scenario’s occurrence is already in the stock price. It is risks not yet observed that usually worry us the most.
4. Price is what you pay; value is what you get
Underlying the value investor’s approach is a simple fact: the quoted price of a security only matters when one is a buyer or a seller of it.
Here is the beauty of what we do: We decide whether and when we are a buyer and a seller.
Mr. Market has to offer us an attractive price that we are comfortable with before we would buy, and has to offer us a great price for a security we own before we would part with it. For the rest of the time, we can sit on our hands and wait.
To further stack the deck in our favor, we do not need to have a view on all (or even the vast majority) of the securities Mr. Market makes quotes on each day. We can simply go to Mr. Market with a shopping list of companies we would love to own at the right price, or rummage through the bargain bin that Mr. Market puts out each day to find great deals.
5. Do not lose money
Value investing as an investment approach is logically coherent but epistemically (and psychologically) difficult.
If we were 100% certain that Company A’s stock was worth $100, then of course we would buy it at $60, and buy even more if it trades down to $30.
But in the real world there are fundamental barriers to knowledge. There’s uncertainty about the future, limits to publicly available information, ambiguities especially in complex systems (limiting the usefulness of the information), and limits to our analytical ability and competence.
One thing we are keenly aware of is that knowledge is slippery, and humbling: we often find that the more we learn about the companies we research, the less we realize we know about them.
Yet we need to hold fast to the belief that there is in fact an “intrinsic value” for a business that we must do our best to estimate.
Intellectual honesty is of the essence: due to agency issues, an analyst can self-interestedly and doggedly insist that intrinsic value of Company A is $100 even if it never trades there, without ever admitting a mistake. Intellectual dishonesty or hubris is deadly for value buyers: stubbornly throwing good money after bad by doubling down on analytical errors (even if they are never acknowledged, even to oneself) is the surest way to lose money.
Soo Chuen Tan is Managing Member of Discerene Value Advisors LLC, a private investment firm that follows a concentrated, long-term, deep value investment philosophy for endowments, foundations and family offices.
