One risk-related consideration should be paramount above all others: the ability to sleep well at night, confident that your financial position is secure whatever the future may bring.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
By controlling risk and limiting loss through extensive fundamental analysis, strict discipline, and endless patience, value investors can expect good results with limited downside. You may not get rich quick, but you will keep what you have, and if the future of value investing resembles its past, you are likely to get rich slowly.
The real secret to investing is that there is no secret to investing. Every important aspect of value investing has been made available to the public many times over, beginning in 1934 with the first edition of Security Analysis. That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain successful.
The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever. So long as people succumb to this aspect of their natures, value investing will remain, as it has been for 75 years, a sound and low-risk approach to successful long-term investing.
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The flaw in such a growth-at-any-price approach becomes obvious when the anticipated growth fails to materialize. When the future disappoints, what should investors do? Hope growth resumes? Or give up and sell? Indeed, failed growth stocks are often so aggressively dumped by disappointed holders that their price falls to levels at which value investors, who subbornly pay little or nothing for growth characteristics, become major holders.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Another conundrum for value investors is knowing when to sell. Buying bargains is the sweet spot for value investors, although how small a discount one might accept can be subject to debate. Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need discipline for selling.
First, sell targets, once set, should be regularly adjusted to reflect all currently available information.
Second, individual investors must consider tax consequences.
Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller.
Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators. Value investors typically begin selling at a 10% to 20% discount to their assessment of underlying value—based on the liquidity of the security, the possible presence of a catalyst for value realization, the quality of management, the riskiness and leverage of the underlying business, and the investors' confidence level regarding the assumptions underlying the investment.
academics and many professional investors have come to define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: a historically more volatile stock is seen as riskier
value investors, who are inclined to think about risk as the probability and amount of potential loss, find such reasoning absurd
in fact, a volatile stock may become deeply undervalued, rendering it a very low risk investment
One of the most difficult questions for value investors is how much risk to incur. One facet of this question involves position size and its impact on portfolio diversification. How much can you comfortably own of even the most attractive opportunities? Naturally, investors desire to profit fully from their good ideas. Yet this tendency is tempered by the fear of being unlucky or wrong. Nonetheless, value investors should concentrate their holdings in their best ideas; if you can tell a good investment from a bad one, you can also distinguish a great one from a good one.
Relative value involves the assessment that one security is cheaper than another, that Microsoft is a better bargain than IBM. Relative value is easier to determine than absolute value, the two-dimensional assessment of whether a security is cheaper than other securities and cheap enough to be worth purchasing.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Someone once defined the best possible business as a post office box to which people send money. That idea has certainly been eclipsed by the creation of subscription Web sites that accept credit cards. Today's most profitable businesses are those in which you sell a fixed amount of work product—say, a piece of software or a hit recording—millions and millions of times at very low marginal cost.
Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash fllow.
Investors also spend considerable effort attempting to assess the quality of a company's management. Some managers are more capable or scrupulous than others, and some may be able to manage certain businesses and environments better than others.
a management's acumen, foresight, integrity, and motivation all make a huge difference in shareholder returns
in the present era of aggressive corporate financial engineering, managers have many levers at their disposal to positively impact returns, including share repurchases, prudent use of leverage, and a valuation-based approach to acquisitions
managers who are unwilling to make shareholder-friendly decisions risk their companies becoming perceived as "value traps": inexpensively valued, but ultimately poor investments, because the assets are underutilized
such companies often attract activist investors seeking to unlock this trapped value
shares of such companies may sell at steeply discounted levels, but perhaps the discount is warranted; value that today belongs to the equity holders of tomorrow have been spirited away or squandered
Another complication is that companies can grow in many different ways—for example, selling the same number of units at higher prices; selling more units at the same (or even lower) prices; changing the product mix (selling proportionately more of the higher-profit-margin products); or developing an entirely new product line.
there is a significant downside to paying up for growth, or worse, to obsessing over it
investors should be especially vigilant against focusing on growth to the exclusion of all else, including the risk of overpaying
Another modern development of relevance is the ubiquitous cable television coverage of the stock market. This frenetic lunacy exacerbates the already short-term orientation of most investors. It forments the view that it is possible—or even necessary—to have an opinion on everything pertinent to the financial markets, as opposed to the patient and highly selective approach endorsed by Graham and Dodd. This sound-bite culture reinforces the popular impression that investing is easy, not rigorous and painstaking.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Cable business channels bring the herdlike mentality of the crowd into everyone's living room, thus making it much harder for viewers to stand apart from the masses. Only on financial cable TV would a commentator with a crazed persona become a celebrity whose pronouncements regularly move markets. In a world in which the differences between investing and speculating are frequently blurred, the nonsense on financial cable channels only compounds the problem.
The only saving grace is that value investors prosper at the expense of those who fall under the spell of the cable pundits. Meanwhile, human nature virtually ensures that there will never be a Graham and Dodd channel.
Greater attention has been paid recently to behavioral economics, a field recognizing that individuals do not always act rationally and have systematic cognitive biases that contribute to market inefficiencies and security mispricings. These teachings—which would not seem alien to Graham—have not yet entered the academic mainstream, but they are building some momentum.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Academics have espoused nuanced permutations of their flawed theories for several decades. Countless thousands of their students have been taught that security analysis is worthless, that risk is the same as volatility, and that investors must avoid overconcentration in good ideas (because in efficient markets there can be no good ideas) and thus diversify into mediocre or bad ones. Of course, for value investors, the propagation of these academic theories has been deeply gratifying: the brainwashing of generations of young investors produces the very inefficiencies that savvy stock pickers can exploit.
another important factor for value investors to take into account is the growing propensity of the Federal Reserve to intervene in financial markets at the first sign of trouble
while the intention of the Fed officials is to maintain orderly capital markets, some money managers view Fed intervention as a virtual license to speculate
so long as value investors aren't lured into a false sense of security, so long as they can maintain a long-term horizon and ensure their staying power, market dislocations by Fed action (or investor anticipation of it) may ultimately be a source of opportunity
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While Graham was interested in companies that produced consistent earnings, analysis in his day was less sophisticated regarding why some company's earnings might be more consistent than others. Analysts today examine businesses but also business models; the bottom-line impact of changes in revenues, profit margins, product mix, and other variables is carefully studied by managements and financial analysts alike. Investors know that businesses do not exist in a vacuum; the actions of competitors, suppliers, and customers can greatly impact corporate profitability and must be considered.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
another important change in focus over time is that while Graham looked at corporate earnings and dividend payments as barometers of a company's health, most value investors today analyze free cash flow
investors have increasingly turned to this metric because reported earnings can be an accounting fiction, masking the cash generated by a business or implying positive cash flow when there is none
following the cash—as the manager of a business must do—is the most reliable and revealing means of assessing a company
in addition, many value investors today consider balance sheet analysis less important than was generally thought a few generations ago
with returns on capital much higher at present than in the past, most stocks trade far above book value; balance sheet analysis is less helpful in understanding upside potential or downside risk of stocks priced at such levels
the effects of sustained inflation over time have also wreaked havoc with the accuracy of assets accounted for using historic cost; this means that two companies owning identical assets could report very different book values
Of course, balance sheets must still be carefully scrutinized. Astute observers of corporate balance sheets are often the first to see business deterioration or vulnerability as inventories and receivables build, debt grows, and cash evaporates. And for investors in the equity and debt of underperforming companies, balance sheet analysis remains one generally reliable way of assessing downside protection.
Most market activity is driven by institutional investors—large pools of pension, endowment, and aggregated individual capital. While the advent of these large, quasi-permanent capital pools might have resulted in the wide-scale adoption of a long-term value-oriented approach, in fact this has not occured.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
institutional investing has evolved into a short-term performance derby, which makes it difficult for institutional managers to take contrarian or long-term positions
rather than standing apart from the crowd and possibly suffering disappointing short-term results that could cause clients to withdraw capital, institutional investors often prefer the safe haven of assured mediocre performance that can be achieved only by closely following the herd
[10] Many investors make the mistake of thinking about returns to asset classes as if they were permanent. Returns are not inherent to an asset class; they result from the fundamentals of the underlying business and the price paid by investors for the related securities. Capital flowing into an asset can, reflexively, impair the ability of those investing in that asset class to continue to generate the anticipated, historically attractive returns.
What would Graham and Dodd say about the hedge funds operating in today's markets? They would likely disapprove of hedge funds that make investments based on macroeconomic assessments or that pursue speculative, short-term strategies. Such funds, by avoiding or even selling undervalued securities to participate in one or another folly, inadvertently create opportunities for value investors.
while Graham and Dodd emphasized limiting risk on an investment-by-investment basis, they also believed that diversification and hedging could protect the downside for an entire portfolio
they attempt to offset the risks for the entire portfolio through the short sale of similar but more highly valued securities, through the purchase of put options on individual securities or market indexes, and through adequate diversification (although many are guilty of overdiversification, holding too little of their truly good ideas and too much of their mediocre ones)
in this way, a hedge fund portfolio could (in theory, anyway) have characteristics of good potential return with limited risk that its individual components may not have
Today's value investors also find opportunity in the stocks and bonds of companies stigmatized on Wall Street because of involvement in protracted litigation, scandal, accounting fraud, or financial distress. The securities of such companies sometimes trade down to bargain levels, where they become good investments for those who are able to remain stalwart in the face of bad news.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
More generally, companies that disappoint or surprise investors with lower-than-expected results, sudden management changes, accounting problems, or ratings downgrades are more likely than consistently strong performers to be sources of opportunity.
When bargains are scare, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don't know when or where. In the absence of compelling opportunity, holding at least a portion of one's portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option.
value investors are bottom-up analysts, good at assessing securities one at a time based on the fundamentals
they don't need the entire market to be bargain prices, just 20 or 25 unrelated securities—a number sufficient for diversification of risk
even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future
value investors, therefore, should not try to time the market or guess whether it will rise of fall in the near term
they should rely on a bottom-up approach, sifting the financial markets for bargains and then buying them, regardless of the level or recent direction of the market or economy
only when they cannot find bargains should they default to holding cash
Recently, Warren Buffett stated that he has more cash to invest than he has good investments. As all value investors must do from time to time, Buffett is waiting patiently.
Nevertheless, 25 years of historically strong stock market performance have left the market far from bargain-priced. High valuations and intensified competition raise the specter of lower returns for value investors generally.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
In addition, because growing numbers of competent buy-side and sell-side analysts are plying their trade with the assistance of sophisticated information technology, far fewer securities seem likely to fall through the cracks to become extremely undervalued.
[8] Great innovations in technology have made vastly more information and analytical capability available to all investors. This democraticization has not, however, made value investors any better off. With information more widely and inexpensively available, some of the greatest market inefficiencies have been corrected. Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important.
Today's value investors are unlikely to find opportunity armed only with a Value Line guide or by thumbing through stock tables. While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided. Consequently, value investors have had to become thoughtful about where to focus their analysis.
Winning, in a sense, was accomplished by not losing. Investors could achieve a margin of safety by buying shares in businesses at a large discount to their underlying value, and they needed a margin of safety because of all the things that could—and often did—go wrong.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Even in the worst of markets, Graham and Dodd remained faithful to their principles, including their view that the economy and markets sometimes go through painful cycles, which must simply be endured.
Of course, just as investors must deal with down cycles when business results deteriorate and cheap stocks become cheaper, they must also endure up cycles when bargains are scarce and investment capital is plentiful.
It is important to note that not all value investors are alike. In the aforementioned "Superinvestors of Graham-and-Doddsville," Buffett numerous successful value investors who have little portfolio overlap.
Some value investors hold obscure, "pink-sheet shares" while others focus on the large-cap universe.
Some have gone global, while others focus on a single market sector such as real estate or energy.
Some run computer screens to identify statistically inexpensive companies, while others assess "private market value"—the value an industry buyer would pay for the entire company.
Some are activists who aggressively fight for corporate change, while others seek out undervalued securities with a catalyst in place—such as a spin-off, asset sale, major share repurchase plan, or new management team—for the partial or full realization of the underlying value.
With today's many amply capitalized and skilled investors, what are the prospects for a value practitioner? Better than you might expect for several reasons.
First, even with a growing value community, there are far more market participants with little or no value orientation. Most managers, including growth and momentum investors and market indexers, pay little or no attention to value criteria. Instead, they concentrate almost single-mindedly on the growth rate of a company's earnings, the momentum of its share price, or simply its inclusion in a market index.
Second, nearly all money managers today, including some hapless value managers, are forced by the (real or imagined) performance pressures of the investment business to have an absurdly short investment horizon, sometimes as brief as a calendar quarter, month, or less. A value strategy is of little use to the impatient investor since it usually takes time to pay off.
Even highly capable investors can wither under the relentless message from the market that they are wrong. The pressures to succumb are enormous; many investment managers fear they'll lose business if they stand too far apart from the crowd. Some also fail to pursue value because they've handcuffed themselves (or been saddled by clients) with constraints preventing them from buying stocks selling at low dollar prices, small-cap stocks, stocks of companies that don't pay dividends or are losing money, or debt instruments with below investment-grade ratings.
Of course, for those value investors who are truly long term oriented, it is a wonderful thing that many potential competitors are thrown off course by contraints that render them unable or unwilling to effectively compete.
Another reason that greater competition may not hinder today's value investors is the broader and more diverse investment landscape in which they operate. Graham faced a limited lineup of publicly traded U.S. equity and debt securities. Today, there are many thousands of publicly traded stocks in the United States alone, and many tens of thousands worldwide, plus thousands of corporate bonds and asset-backed debt securities.
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In 1992, Tweedy, Browne Company LLC, a well-known value investment firm, published a compilation of 44 research studies entitled, "What Has Worked in Investing." The study found that what has worked is fairly simple: cheap stocks (measured by price-to-book values, price-to-earnings ratios, or dividend yields) reliably outperform expensive ones, and stocks that have underperformed (over three- and five-year periods) subsequently beat those that have lately performed well.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
Investors tend to assume that tomorrow's markets will look very much like today's, and, most of the time, they will. But every once in a while, conventional wisdom is turned on its head, circular reasoning is unraveled, prices revert to the mean, and speculative behavior is exposed as such.
"We have stiven throughout to guard the student against overemphasis upon the superficial and the temporary, [which is] at once the delusion and the nemesis of the world of finance."
they laid out a plan for how investors in any environment might sort through hundreds or even thousands of common stocks, preferred shares, and bonds to identify those worthy of investment
While formulas such as the classic "net working capital" test are necessary to support an investment analysis, value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required.
[6] Graham and Dodd recommended that investors purchase stocks trading for less than two-thirds of "net working capital," defined as working capital less all other liabilities. Many stocks fit this criterion during the Depression years, far fewer today.
For one thing, not all elements affecting value are captured in a company's financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over- or understated.
Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range.
Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.
Sometimes a stock becomes cheap for good reason: a broken business model, hidden liabilities, protracted litigation, or incompetent or corrupt management. Investors must always act with caution and humility, relentlessly searching for additional information while realizing that they will never know everything about a company.
Value investors regard securities not as speculative instruments but as fractional ownership in, or debt claims on, the underlying businesses.
—Seth A. Klarman, The Timeless Wisdom of Graham and Dodd
financial markets are the ultimate creators of opportunity
sometimes the markets price securities correctly, other times not
in the short run, the market can be quite inefficient, with great deviations between price and underlying value
the price of a security is frequently an essential element, so that a stock may have investment merit at one price level but not at another
those who view the market as a weighing machine—a precise and efficient assessor of value—are part of the emotionally driven herd
those who regard the market as a voting machine—a sentiment-driven popularity contest—will be well positioned to take proper advantage of the extremes of market sentiment
[2] Over the long run, however, as investors perform fundamental analysis, and corporate managements explain their strategies and manage their capital structures, share prices often migrate toward underlying business value. . . . This tendency, however, is always subject to interruption by the short-term forces of greed and fear.