June 12, 2013 – Favorites from Seth Klarman’s Value Investing Ideas

Evening,

I’m sending you guys a good read.  It’s from Seth Klarman, one of the best value investors around the world and legendary like Warren Buffett is.  He shares a lot of his ideas in his book “Margin of Safety” and talks about how these volatile price fluctuations should be seen in two ways (permanent loss or interim price fluctuation).  He also talks about ideas as “selling when you want to instead of selling when you have to.”  In general, obviously the market in the Philippines is going down because we have inevitably reached a huge run-up as well as the other facts that Philequity Corner wrote about (see Anatomy of a Correction, Philequity Corner June 10 2013).  How much the pullback will be is only a mixed bag from people’s nervousness, intraday volatility from weakening peso and other emerging market currencies.  There are two choices – sell now to buy lower, or hold what you have and buy more lower.  We are in a longer term secular bull market.  The ability to have some cash on your side (makes you take advantage and dictate the price you will bid at.)  If people look at their strengths, which means their Philippine SDAs that can be put to work, then the market slide will be a welcome pullback for the new set of investors.  Inevitably, the people who are already invested in blue chips will take some time before prices stabilize and get back to normal.  What we are saying is that the market advice is not the same for each person.  For longer-time frame clients and those who are cash rich, this volatility creates a lot of values and bargain hunting opportunities.  Imagine if you can get a 30% or 40% discount on a company whose fundamentals have remained the same (or even doing better) but is simply sold down because of the massive leverage that foreign funds have in emerging markets (who are stopped out due to their currency losses and short term stock market declines?)

Our clients are not leveraged.

Our clients are people who have invested perhaps 10-20% of their net worth in the Philippine equities.

If you are 100% invested (and your net worth is volatile due to market fluctuations), then you have some selling to do.

If you are just 15% invested (even a 40% or 50% decline in stock markets wouldn’t affect anything in your lifestyle.)

The point is that we cannot play offense (if we had already deployed our cash, but if we hadn’t then now’s a great time to slowly start if we fall another 5% in the index in the next couple of weeks) but we cannot play maximum defense either.  The most that we can do is to think rationally despite the market’s volatility.

Hope this helps and just stay sane and 🙂

Exercising and doing some running can help us focus on the businesses as well as maintain better health. (They say stress makes traders and brokers fat which is true so I have to go run to think rationally.

(Mark the portfolio down 10-20% so that if that loss is fine, you are already fine.  The next coming days will be a wild ride.  We will have rollercoasters and some people cannot sleep at night when they have their portfolios moving in these wild ways.  The thing is —- how much can you afford to lose?  I think a lot of people have already answered this and so, I have been selling for some clients… but if there’s already 40-50% in cash, we don’t need to go to 90-100% cash level unless you really want to.)

Also I’ve always been a bull at heart.  What happens after a sell off is always a better longer term return 🙂

We just need to be more diligent in our bargain hunting.  We’ll update valuations when there are some irresistible bargains.

-FT

 

*****

30 Ideas of Value Investing from Seth Klarman’s Margin of Safety

Read fully here: http://www.safalniveshak.com/wp-content/uploads/2013/05/30-Ideas-from-Margin-of-Safety.pdf

Personal Favorites Below:

1.) Value Investing isn’t Easy

Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon.

Like most eighth- grade algebra students, some investors memorize a few formulas or rules and superficially appear competent but do not really understand what they are doing. To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough.

Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don’t when they don’t. Value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned.

2.)  Being a Value Investor

The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline.

Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking.

A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

3.)  Don’t Seek Mr. Market’s Advice 

Some investors – really speculators – mistakenly look to Mr. Market for investment guidance.

They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings,ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead,buy in at the higher figure as if he knew more than they.

The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.  Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying long-term success.

4.) Stock Price Vs Business Reality

Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market.

The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.

It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces.

5.) You cannot ignore the market – ignoring a source of investment opportunities would obviously be a mistake but

you must think for yourself and not allow the market to direct you.  Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.

The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance.

Indeed, the short-term, relative-performance orientation of many money managers has made “institutional investor” a contradiction in terms.

Most money managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management. The incentive is to expand managed assets in order to generate more fees. Yet while a money management business typically becomes more profitable as assets under management increase, good investment performance becomes increasingly difficult.

6.) Permanent Versus Interim Price Fluctuations

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.

But are temporary price fluctuations really a risk? Not in the way that permanent value impairments are and then only for certain investors in specific situations.  It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact.  While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.

7.) Sell When You Want To, Not When You Have To

For example, short-term price declines actually enhance the returns of long-term investors. There are, however, several eventualities in which near-term price fluctuations do matter to investors. Security holders who need to sell in a hurry are at the mercy of market prices. The trick of successful investors is to sell when they want to, not when they have to.

 8.) The Importance of Short Term Price Fluctuations 

Long-term-oriented investors are interested in short-term price fluctuations because Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

9.) Complexity of Business Valuation

It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen.

Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun.

If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot.

10.) How much Bad Luck Can You Tolerate?

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.”

 A margin of safety is necessary because…

• Valuation is an imprecise art

• Future is unpredictable, and

• Investors are human and do make mistakes

11.) How much bad luck are you willing and able to tolerate? How much volatility in business values can you absorb? What is your tolerance for error? It comes down to how much you can afford to lose.

12.) How To Protect Yourself

There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.

13.) Value Investing and Contrarian Thinking

Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.

If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued.

Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.

Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome.

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2 Responses to June 12, 2013 – Favorites from Seth Klarman’s Value Investing Ideas

  1. wilson says:

    missing ur posts

    Like

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