FPTP

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 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.

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.

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.

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

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

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.

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.

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.

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.

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.

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