This page is supposed to summarize the most important aspects of (my) value investing philosophy and my investing approach, which will evolve over time. So I expect this page to evolve too. If it does not, it probably means that my journey as an investor is not going as planned. I hope to refine my investing philosophy and approach … Hopefully a successful one!
Here is an 6 step manual for my value investing philosophy and this page’s index
- Investing is simple (if we)
- Know fair values (and only)
- Buy companies with a margin of safety.
- Have the right mind for a value investor.
- Focus on risk and (not maximum) return.
- Good and refined research process (feeds into)
- Sound portfolio management.
- Investment goals
- A range ov value (stocks vs bonds)
- Value Investing vs Modern Financial Theory
1) Investing is simple …
… but not easy! In theory, simply buying stocks at low(er) prices and selling them later at high(er) prices is all it takes to make a profit. That’s how all retailers operate, buying things for less than selling them to us. But, we do not know for what we can sell a stock or security for in the future, thus we do not know when to buy or at what price.
What not to do
Do not act as a speculator (buying a security on the merit that the next price you could sell it for will be higher). Buying decisions have to be based on a sound valuation resulting in a significant undervaluation. — For me it’s easier to follow that advise through this blog, since I make my decisions public and up for discussion.
Do not trust Wall Street. Most people want to sell you sth., proclaim to know how the market will move the next day, week, month or year on business TV. Build your own opinion.
Do not engage in the relative performance derby, you can’t eat relative performance. Care about ablsolute performance without taking too much risk for your personal situation and financial goals.
2) Know fair values
Since we can usually not trust other market participants, i.e. brokers, we have to figure it out on our own. Even if we trust others, our conviction will be higher in cirtical moments when we did our own research and draw our own conclusions.
Business valuation is imprecise and more art than science. It is just impossible to pin an exact value to your home, so why should it ever be possible to exactly value a business, which is way more complex than a house (see a range of value).
Any attempt to value businesses with precision will yield values that are precisely inaccurate.Margin of Safety by Seth A. Klarman (1991), p.118
Conventional valuation yardsticks such as earnings (per share), book value and dividend yield have their place in securitties analysis, but they must be used with caution and should only be part of a more comprehensive analysis of underlying value.
Be wary of methodically highly sophisticated models, because the chance is that the modeler delved right into the conceptual engineering part (methods) without wasting much time on thinking about the inputs (assumptions). Always remember, it is Garbage in, garbage out!
3) Buy with a Margin of Safety
Buying securities at a significant discount to their current underlying fair value or intrinsic value and hold them until the gap has narrowed. This is the essence of (value) investing. This is often described as ‘buying the dollar for fifty cents‘. Ideally the dollar increases its value over time, say becoming worth two dollars.
The neccesary pre-condition
to call an approach (value) investing is to
estimate the underlying value
of a potential investment.
According to Buffett (1984), this concept takes with people immidiately or not at all.
Value investing is very much a risk-averse approach since you only buy those securities which are to be had at a significant discount (to their estimated fair value). Additionally it is required, only to invest in understandable and not too risky companies as well as only to act on the best opportunities (relative to other discounted securities in our watchlist) or to say ‘waiting for the right pitch‘. Maintaining discipline is harder than it sounds. Often value investors are against the investment crowd or the market and are indeed contrarians and lonely.
Valueing businesses is very complex and there are a lot of variables involved. Thus the estimated fair value of the business is only a best guess within a range and is never certain. It is impossible to know all relevant facts and they can change every single day. Ultimately, you could be wrong with your estimated fair value. It is only important to be right more often than wrong. It is very important to be aware of that involved uncertainty. The true fair value could be higher or lower than estimated.
A margin of safety allows for getting things wrong. According to B. Graham, when buying assets at a discount to (estimated but uncertain) underlying value you get a margin of safety allowing you to get for getting various sorts of things wrong, such as human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.
4) Have the right mind
Answering why you are able to buy an asset at a discount is important (it helps our conviction). As well as to check after the purchase is made if the reason(s) for buying still persists. Additionally, its important to acknoledge, that value investing (sometimes) works best in a declining stock market as the rising tide lifts all ships. Acording to Seth Klarman:
Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment.Margin of Safety (1991)
Investors need …
- Discipline to avoid the many unattractive pitches that are thrown at you
- Patience to wait for the right pitch
- Judgement to know when it is time to swing (hard)
Additionally, we have to be simulataniously confident and humble. We have to trust our thourough analysis and be confident enough to buy (much) or add (more) if we identify a bargain where the odds are on our sides. But, we must admit that we can always be wrong. Thus we should never bet the house, but we want to make each portfolio position important enough to have an impact but not big enough to risk our survival.
Strive for absolute-performance. Do not fall for the relative performance orientation constantly comparing to other investors (this is mostly the game of institutional investors). As Klarman frames it: You cannot, after all, spend relative performance. In bull markets, that can be a strain to (y)our mental wellbeing, but we are in it for the long-run. Investing is a marathon, not a sprint and it is about high absolute risk-adjusted returns over a long period.
5) Focus on risk (and return)
Care about risk and return. For value investors, it’s important to understand that risk is not volatility of the daily quoted price per phare.
Risk and return must instead be assessed independently for every investment. In point of fact, greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.Margin of Safety by Seth A. Klarman (1991), p.111
Understanding the nature of risk is important. Many investors struggle with that.
The risk of an investment is described by both the probability and the potential amount of loss. The risk of an investment — the probability of an adverse outcome — is partly inherent in its very nature. A dollar spent on biotechnology research is a riskier investment than a dollar used to purchase utility equipment. The former has both a greater probability of loss and a greater percentage of the investment at stake.Margin of Safety by Seth A. Klarman (1991), p.111
Risk also depends on the price paid. Everything else equal, it is obviously less risky to buy a certain stock at 50 dollars, than to buy it at 100 dollars.
To counteract risk investors should diversify adequately. Every investment decision involves certain risks, of which some might be obvious, but others are not.
6) Research process
The value investment process generally consists of two domains. Investment research is about gathering information about potential investment opportunities, building an opinion and value the business.
Do bottom-up investing. According to Klarman, you should analyse specific companies instead of buying into a certain industry or region based on some macro economic notion or perceived trends in consumer behavior.
Initial idea generation can happen at any time and can result from any imaginable source, for example on vacation. Lists of shares with the worst performers might reveal an undervalued out-of-favor asset. Companies which eliminate its dividend payments might experience (temporarily) undervaluations, since a valuation anchor went missing. Institutional constrains can result in attractive opportunities and it might be worthwhile to look into such areas as small caps, newly created spin-offs, low-priced security, securitties not included in any index, depressed prices driven by the calendar.
- Looking at the most fertile hunting grounds might yield best results.
Specific company reasearch on a deeper level is to done after finding a new idea that has the potential to offer an attractive proposition and passes a quick test for quality.
Valueing a company is a critical step. The valuation model does not have to be very sophisticated. The valuation does not have to be precise, a range of fair value is fine. But you have to value the business.
Assessing the proposition means comparing your estimated fair value to the current market price. If it can be bought at a higher discount than your required margin of safety, it could be an attractive opportunity, depending on the risk/reward profile compared to other available options (holding cash included) and your current portfolio composition. If you come to the conclusion that the company is currently undervalued and you invest in it, it is important to believe that…
Undervaluations get cured eventually. According to Vitaliy Katsenelson’s email-series 6 commandments (#6), this can happen over time through (a) the company buys back stock, reducing the number of shares outstanding dramatically, with the result of much higher earnings per share, or the company (b) pays out its earnings as dividends, creating yields that the market will not be able to ignore, or (c) competitors will buy the company, since it is cheaper than to replicate its assets.
Monitoring companies is an ongoing task, mostly it is about filtering the noise distinguishing between unimportant daily news and relevant events.
Updating valuations of researched companies is only necessary if there are relevant news or assumptions changed significantly.
Maintaining a watchlist should be the result of your investment research process. If you conclude that a high quality company is currently overvalued, you might want to get notified if it gets undervalued, based on your prior valuation. To maintain a watchlist that includes a few companies with their fair value and buy price per share is a good preparation for market sell offs. If they happen you can double check or update your valuation and act accordingly …
7) Portfolio management
Portfolio management and trading is about
- managing risk on the portfolio level and
- deciding when to buy or sell and
- how to size a position or transaction.
Diversification is managing the relative size of different investments to the portfolio, mostly accomplished investing into 15 single securities (randomly selected). But, it’s not about the number of investments. It’s about how different the things you own are in the risks they entail an how they will behave in different scenarios/environments. It might be preferable to own companies in different industries and regions with business models; overall businesses that might be affected by various risk factors by varying degrees.
How many positions to hold is an important decision. But the number of investments should (a) provide some diversification and (b) it should still be feasable to follow each investment regarding limited time available. Finding the sweet spot takes some time I believe and may vary to market conditions.
To size each position in the right way within your risk management framework is important. On the one hand, you want to maximize (potential) rewards, by investing in opportunities with the highest expected payoff. This is the discount to estiamted fair value (or the possibility that others pay above that). On the other hand, you want to limit the role of luck and possible effects from errors done analyzing companies. Relatively speaking, a position should be bigger with: higher expected returns, lower downside, higher visibility, higher overall quality and lower risks.
Portfolio Management and Trading
Specific investments might have a beginning and an end, but portfolio management goes on forever, investors must come to terms with its continuity.
Portfolio management encompasses trading activity as well as the regular review of one’s holdings. In addition, an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.Margin of Safety by Seth A. Klarman (1991), p.209
Only placing orders when markets are closed is an effective way to block out the daily noise and daily market moves. Coming to the conclusion that a stock is significantly undervalued and not pulling the trigger only because the stock moves upwards at a given day might result in deep regrets.
Investors should usually refrain from purchasing a full position (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to average down, lowering their average cost per share, if prices decline.Margin of Safety by Seth A. Klarman (1991), p.215ff
Buying an initial starting position instead of a full position brings certain advantages. First, you can buy a small position and get to know if it feels good to be a co-owner of the business. This starter position can be bought before finishing researching the company in full. Owning the company, might bring you to notice business variables you would otherwise not be aware of. Second, a partial position gives you the opportunity to average down, if the price declines, lowering your average cost per share.
Averaging down is a nice strategy – But you have to be sure that your valuation is still valid. Search for possible errors made and stres test you assumptions and ask What must happen, to make the stock fairly valued?
At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.John Hempton, brontecapital
Selling decision can be much harder than buying decisions. To know that a security is undervalued is easier than to know exactly when the margin of safety does not meet your requirement anymore. Regrets about selling too early can appear years after the desion was executed. As Seth Klarman writes in Margin of Safety (1991):
Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.
It can be hard to let go of a company that you spend a lot of time analyzing. When selling, you kind of stop profiting from all that hard work. Anyway, it is hard not to fall in love with an investment. You analyzed the business to know if it is undervalued and when it is not.
As an investor it is important to avoid losses and to limit risk taking. This should be done for companies and on a more aggregated portfolio level. Depending on how you answer the below questions, one should (not) pursue a certain investment strategy.
Do you want to invest on your own? Outsourcing ones investing issues to a professional can be a viable choice.
Do you want to spend above average time on investment topics? Afterall, you could just work instead of using your time for investing topics and earn money.
What losses are you willing to bear? This is not an easy question. During a market rout many people experience that they answered this question with a number too high and their real tolerance for losses was much lower indeed.
Personally, I have a stream of monthly cash inflow (called salary) and I will (sadly) work for a few decades more until starting my life as a happy retiree. Based on my personal circumstances and answering the first two questions with a ‘yes’ …
I came to the following conclusions. I can stomach my equity porfolio to (temporarily) lose half its market value, since I can wait for a recovery (retirees might be in another position). Furthermore, I might take highly concentrated portfolio positions (more here), since I make frequent contribution to the investment portfolio.
A range of value (bonds vs stocks)
Bonds can be valued rather straight forward, basically the bonds current price is the sum of its discounted contractual cash flows (interest payments + pricipal repayment). The discount rate is calculated as risk free rate (as per maturity) + a spread, depending on the default risk (and other things like liquidity).
Equity securities are much harder to value compared to bonds. This is because, stocks to not entitle the owner to contractual cashflows (like bonds).
Equity securitites represent fractional ownership of a business. Earnings or cashflows of this business can either be reinvested or spend (cash outflows), stay in the business (cash in a bank account), or be payed out to business owners as dividends (buying back shares is another way of returning cash). The business’ earnings again are dependable on so many factors (some of them might be very important, some less so), that it is impossible to estimate each factor precisely and its effect on earnings with precision.
The distinction between value and growth investing is artificial, since investing is always about the future and growth is incorporated into a sound valuation. As Howard Marks argues, value investing is more about investing based on the current (or near term) characteristics of the assets nad value of the business. Compared to this, growth investing is more based on the (future) potential, what a business is to become. Thus, often the range of value is even wider for the latter.
The essential point is: You do not have to determine exactly what’s the intrinsic value of a business. It is enough to come to the conclusion, that the intrinsic value of a business is considerably higher than current market value.
Do not fool yourself. If expert analysts with extensive information cannot gauge the value of high-profile, well-regarded businesses with more certainty than this, investors should not fool themselves into believing they are capable of greater precision when buying marketable securities based only on limited, publicly available information.
Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish.
Value Investing vs Modern Financial Theory
Modern Financial Theory frequently clashes with a value investing philosophy. Each and every finance student will have heard about the efficient-market hypothesis which basically states that all securities are fairly priced.
Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.Margin of Safety by Seth A. Klarman (1991), p. 98
Within this context, Klarman points to the fact, that “large cap stocks tends to be more efficient than that of small cap stocks, (…) and other less-popular investment fare”. And Marks describes it as a matter of degree. There might me more and less efficient markets.
Beta (β) is useless as a gauge of risk involved with any security or certain stock as used in the CAPM framework, according to Klarman. Beta assigns a risk to a stock depending on its historic price developments in conjunction with a (market) index. The riskiness of a stock is not dependent on its short-term price fluctuations but on the probability and (weighted) magnitude of loosing capital permanently.