Lektioner fra 20 investeringsbøger, del I: Metodologien

Reflection

Lessons from 20 value investing books, part II: The methodology

October 29, 2017

This post is also available in: Dansk

Abstract

  • This blog post is the second of three in a series that attempts to distill the key take-aways from 20 value investing books. The second domain, which is covered in this post, concerns the value investor’s methodology.
  • In short, the approach is characterised by a search for bargains, those businesses that are offered at a significant discount to intrinsic value, thus offering a wide margin of safety. Intrinsic value can be assessed using various models, but the main principle is the same across: buy 1 dollar for 50 cents.
  • The one thing value investors cherish above all else (even returns!) is safety. Risk is defined as the likelihood for and amount of capital loss. By considering risk first, you avoid those large downturns that require many succesful trades to break-even.
  • The idea of finding assets  that offer a large upside while minimizing the downside risk is embedded in the Dhandho-mantra: “Heads, I win; tails, I don’t lose much.”

If you haven’t read part I of this posts series, I’d recommend stopping by that one before delving into the below. In part I, I attempt to sketch-out the mindset necessary to be a true value investor. In this post, I’ll leap forward and discuss the methodology behind the objective of value investing: spotting bargains.

Margin of safety and the quest for bargains
It was mentioned in part I that upon thorough analysis one should be able to assess a business’ intrinsic value, or fair value, the price a security should be trading at as so forth the market was governed exclusively by intelligent buyers and sellers.

There are an array of methods one can employ to assess a business’ intrinsic value. Here on dhandho.dk, I’ve presented Benjamin Graham’s net-nets and going concern value formulas (read Value Investing Made Easy). You could also do reproduction cost analysis to determine what kind of capital it would require for a competitor or entrant to acquire a similar asset base and achieve the same earnings power (read Value Investing: From Graham to Buffett and Beyond and The Rational Investor). You could also do a discounted earnings and dividend analysis (read Why are we so clueless about the stock market?). Finally, the most widely employed by analysts and yours truly, the Discounted Cash Flow model, has been outlined in How much is LEGO worth?

You need to assess the situation and employ the method most appropriate for a given security at a given time. For instance, ask yourself: Is this company threatened by bankruptcy/severe financial challenges, or does the business have a solid capital structure? Are the earnings somewhat predictable, or are profits subject to swings? Is the business operating in a stable or cyclical industry?

Regardless of methods, a security analysis flows into a valuation/assessment of intrinsic value. The gap between said value and the price the stock is trading at, is your margin of safety. If you conclude that a stock is worth $100, and it’s currently trading at $70, you have a 30% margin of safety (which is the minimum requirement you should insist on according to Benjamin Graham). Squarely put, the stock that offers the greatest margin of safety is your best bet (though, of course, you need to consider an array of variables to determine whether or not your comfortable with placing the bet).

If you’re missing a practical example of such valuations, you can take a look at one of my stock analyses, e.g. Sports Direct (SPD) or Foot Locker (FL).

A risk-averse philosophy and strategy
The margin of safety principle is the value investing philosophy’s corner stone, since it captures what value investors cherish above all else (even returns!): safety. A recurrent mantra that is echoed the 20 books I’ve read so far goes something along the lines of: “Do not try to capitalize on the future; protect yourself against it.”

Don’t get me wrong; value investors naturally crave returns. However, returns are secondary. If there aren’t any fat pitches you can swing at due to e.g. an overpriced market, the value investor sits still. To underscore this prioritization of safety above returns, take notice of Benjamin Graham’s definition of investing from Security Analysis: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” In addition, Howard Marks teach us that value investors believe high returns and low risk is achieved simultaneously by acquiring assets for less than their worth (read The Most Important Thing).

In length, the author of Margin of Safety, Seth Klarman, explains that one of the three key elements of the value investing philosophy is risk aversion. He argues that lack of consideration to loss of capital is the essence of risk, and thus the root of investment failure. Such large losses require many successful deals simply to break even. By focusing on risk – defined as the likelihood for and amount of capital loss – first, you avoid these large downturns. Considering risk in such a manner will ensure that you outperform the speculators’ results.

A neat metaphor for this line of thinking can be found in The Little Book of Value Investing. Christopher Browne suggests that you adopt the mentality of a banker who’s about to issue a loan. He would start out by assessing the risk through an analysis of the borrower’s ability to pay back the amount in full. What is his disposable income? Are there assets that may act as cushion in case of trouble? To what extend is the borrower’s ability to meet his obligations impaired if his income falls? Ask such questions in a business context to better evaluate the investment’s risks.

Uncertainty is not risk
In length of the afore paragraph, it should be noted that uncertainty and risk are not synonyms. This is a distinction Wall Street has difficulties comprehending, according to Mohnish Pabrai (read The Dhandho Investor). The Street regards them as two sides of the same coin. Mohnish blatantly disagrees. He considers risk as the likelihood of capital loss. Uncertainty revolves around the number of outcomes and the unpredictability of the future. For instance, Wall Street analysts might not be able to spot the way-out of a tricky situation, but if the company is trading at a significant discount to tangible assets, where’s the risk?

Wall Street often ventures into fire sales when the future seems uncertain. These traders rush to the sales desk, hence driving down prices to depressed levels. That creates opportunities for Dhandho-investors, e.g. by snatching up businesses with solid earnings histories at low multiples, merely because of short-term challenges. Also, truly great business franchises protected by strong moats are on sale periodically when entire markets plummet.

The tip is thus: Be on the lookout for opportunities with low risk and high uncertainty. This combination often leads to undervaluation, which the intelligent investor may exploit. Be aware though, it requires the courage of a contrarian and a rational mindset to be able to take advantage of Mr. Market’s weaknesses. But that is the very essence of a value investor: daring to think and act differently. Remember, Howard Marks recommends dusting off the loop when first-level thinkers go: “Who on earth would want to own that?” The necessary condition for a bargain to surface is that the perception is worse than reality. Bargains are found among that which others do not want to touch: the complicated, the doubtful, the controversial, the scary and the unloved.

The Dhandho Way: Heads, I win; tails, I don’t lose much
The distinction between risk and uncertainty is the perfect bridge to what I consider the heart of value investing: the Dhandho-mantra. The idea of finding assets  that offer a large upside while minimizing the downside risk is embedded in said mantra: “Heads, I win; tails, I don’t lose much.” Obviously, such opportunities are few and require a certain type of mindset to exploit (read part I of this posts series). Anyhow, I’ll try to outline my – although still young – approach to spotting these candidates in part III.

This post is also available in: Dansk

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