Margin Of Safety
VALUE INVESTING - Where most investors stumble?
Speculator and Unsuccessful Investors
Klarman argues that most market fluctuations are the result of day-to-day distortions between supply and demand of particular stocks, not of changes in fundamentals. Investors who take advantage of these distortions by focusing on the fundamentals will be successful. Those who invest with their emotions are sure to fail in the long-run.
Wall Street
What’s good for Wall Street is not necessarily good for investors, according to Klarman. Because of how Wall Street does business, it has a very short-term focus. For example, Wall Street makes money up-front on commissions (not from long-term performance), therefore the Street will always push for churn and will always push “hot” investments.
Institutional Investor
From 1950 to 1990, the institutional share of the market rose from 8% to 45%, and institutions comprise 75% of market trading volume. But the institutions are hampered by a short-term mindset
Junk Bonds
One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn’t include depreciation expenses. Klarman argues that a company paying its debts from EBITDA is slowly liquidating itself (as it can’t make capital expenditures) and leaving itself susceptible to a credit crunch.
VALUE INVESTING PHILOSOPHY
Defining Investment Goal
Importance of Margin of Safety
Value investing is described as paying 50 cents for a business worth $1. Warren Buffett’s analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
do not buy businesses they do not understand, nor ones that they find risky.Again Klarman uses a Buffett analogy to illustrate this:
A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.
Since institutions do not buy with a margin of safety, remain fully invested at all times, and trade stocks like pieces of paper with little regard to the underlying asset values, value investors gain an advantage.
Roots of Value Investing
Art of Business Valuation – 3 ways to value a business
(1) Klarman discusses what he believes to be the only three ways to value a business. The first method involves finding the net present value by discounting future cash flows. Problems with this method involve trying to predict future cash flows, and determining a discount rate. Klarman argues that investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.
(2) The second method is Private Market Value. This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. The problems with this method are that comparables assume businesses are all equal, which they are not. Furthermore, exuberance can cause business people to make silly decisions. Therefore, basing your price on a price based on irrationality can lead to disaster. Klarman believes this to be the least useful of the three valuation methods he names.
(3) Finally, Klarman discusses liquidation value as a method of valuation. A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. Fixed assets can be difficult to value, as some thought must be given to how customized the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).
VALUE INVESTING PROCESS
Research
To find devaluled asset is very tough.So one needs to find at the right places :
new low lists and the largest percentage decliners lists
companies whose dividends have been cut or eliminated
what management is doing with respect to the company’s stock
consider why a stock is performing poorly
Areas of Opportunity- Catalysts, Market Inefficiencies, Institutional Constraints
details of a no of securities who paid attention to fundamentals
(businesses marked by unprofitable divisions, companies trading at discounts to cash, etc.)
catalyst- events that cause a stock’s value to be recognized-a liquidation(during bankruptcy events, where securities generally trade at a discount to their recoverable values)
Partial catalysts-share buybacks and asset sales- can cause a stock to inch closer to its underlying value.
areas where investors can find value – liquidations,complex securites,rights offerings,spinoffs, risk arbitrage
Thrift Conversions
Banking sector – in 1980 and 1990 many banks were selling for less than book value.
big banks were analyzed, but small and mid sized shops were trading at inefficient prices
some aspects of valuing banks -unanlyzable- if they deal in junk bonds or complex mortgage securities or other exotic instruments. Conservatism is very important due to the fact that they are highly leveraged and thus already contains a certain amount of risk.
good start – book value – adjusted upward for understated assets
such as appreciated investment securities, below-market leases, real estate
adjust value downward – intangible assets, bad loans and poor investmens that are carried at cost
No sure things in this indusry – major role played by
asset quality
management discretion
interest rate volatility
pick low risk individual banks and wait
Jamaica Savings Bank
Financially Distressed and Bankrupt Securities
Three reasons that a firm may run into distress
operating issue
legal issue
financial issue
Issuers can respond to such situation in one of three ways
continue to pay obligations
default
declare bankruptcy
Investors should understand the implication to their investment if each of this scenarios play out
Investors should also understand the power that various stakeholders have
complex instrument and difficult to analyse, investors are in a position to loose all of their investment
analyzing financially distressed securities starts at the balance sheet
assets should be valued so that the size of the pie can be estimated
obligation should be submitted from this amount
For a distressed company, asset values are usually a moving target, and getting a handle on their value an be difficult
Off balance sheet liabilities must also be considered
Two great examples
Portfolio Management and Trading
Portfolio management is an ongoing process that is never complete
while certain businesses are never stable, its prices will fluctuate over time, so the investor must constantly monitor the situation
Klarman also points out the need for portfolios to be somewhat liquid
Investors are advised not to purchase their entire postion at one go
Determining when to buy a stock is usually a much easier decision for a value investor, since the stock at that time is trading below what the investor considers an adequate margin of safety.
But when the stock is trading within the range of values the investor believes it to be worth, what is the investor to do? Klarman argues against selling after percentage gain thresholds or price targets have been reached. Instead, the investor should compare the investment to available alternative investments: it would be foolish to sell if there were no better investments and the stock was still undervalued, but it would be foolish not to sell if there are better bargains around!
Investment Alternatives
For people who cant manage their own money two options are left:
1) Mutual Funds
2) Money Managers
Closed-end funds do not offer investors ready liquidity at net asset value, however, they may be prudent investments when they trade at substantial discounts to their net asset values. Under the mutual fund banner, Klarman recommends the Mutual Series Funds and the Sequoia Fund.
In evaluating money managers, Klarman suggests individual investors raise the following questions which will help select a manager:
Do they manage their own money in parallel with their clients’?
Has the size of the portfolio grown exceedingly large?
What is the investment philosophy of the manager? Does it make long-term sense?
In evaluating investment results, investors must look deeper than a manager’s historical investment returns. For example, any manager can generate phenomenal returns within a certain period of time. Are the returns described over at least one full business cycle? Also, were the returns generated using leverage, or were they generated despite the portfolio holding large amounts of cash (in which case risk is much lower)?
This book is an interpretation of my understanding of the matter. To better understand the book, it is highly recommended to read the book. The book can be bought at the following link: