Lecture 1 for Lesson 1, Readings: Margin of Safety and Mr. Market from The Intelligent Investor, Preface from the book, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance) by Tobias Carlisle, and Behavioral Portfolio Management.
A rambling, REPETITIVE lecture, but stay with me.
Thanks for those who sent their answers. Your replies help me assess who is in the class. We have almost 500 students enrolled and many seem knowledgeable and astute. I will collate and then post some of the “student” answers. I place student in quotation marks because we are all students here. If you request something or ask a question and I don’t respond, please place in block letters in an email to firstname.lastname@example.org, SECOND REQUEST. Typically, I respond within 24 hours, but I receive hundreds of emails, so don’t take it personally if I am slow to respond or your email request is lost.
Let’s sit down and discuss why I sent you these readings.
All intelligent investing is value investing—acquiring more than you are paying for. You must value the business in order to value the stock. – Charlie Munger.
I think of investing as trying to buy bargains typically when other investors feel, need, or must sell urgently. If we are correct in our assessment of intrinsic value, (“IV”)–defined through future discounted cash flows or private market value between two cogent investors–then Regression to the Mean should work over a reasonable time to close the gap between the price we paid and IV. Note that Graham NEVER discussed how to calculate intrinsic value.
Valuation is subject to judgment and it is often a range of values depending upon our assumptions and cost of capital. Often we can’t value a company because of our lack of expertise. The market provides a place where prices are offered or bid on securities (bonds/stocks) of underlying businesses. Since we are prone to error as are all other investors we build in a Margin of Safety by waiting for a large enough discount in the price paid to IV, by using conservative assumptions, diversification, and by staying within our circle of competence. Margin of safety is central to the attitude of a deep value investor. Margin of Safety by Seth Klarman is an excellent book along with The Intelligent Investor (to be emailed later) to learn of the ATTITUDE of the true value investor. We also should be aware of who is on the other side of the trade from us. If the price of a company’s stock is dropping while insiders are selling heavily, we had best reconsider our assumptions.
Deep Value: We are the enemy!
So here is our dilemma. We as Deep Value Investors (“DVIs”) seek to identify measurable and persistent behavioral price distortions and then capitalize on those distortions. In other words, when people go crazy, we seek to take advantage. But people over-react, go crazy, fear loss, seek out certainty, and herd together because they are human, but so are we. What makes us special? Won’t we fall prey to those same biases? We will explore this further in the course.
Deep Value: What is Value Investing?
If you asked John Neff, Peter Lynch, Ben Graham, Seth Klarman, and Charlie Munger they might say basically the same thing, buying a business for less than its worth, but their portfolios might all be different. We will be focusing on Deep Value stocks. These are losing stocks that become asymmetric opportunities with limited downside and enormous upside. Yes, but aren’t we trading off big upside with big risk? If we factor in the risk of loss then are we really obtaining a bargain? What about value traps where value erodes as fast as price? The key for us to focus on in this course will this second dilemma. Deep value stocks may have a higher risk of bankruptcy individually, but as a group, the risk is OVERCOMPENSATED. In other words, we are highly compensated for taking the other side of the distressed selling. Is that statement true? If investors over-react due to various biases like recency-bias, loss aversion, myopia, etc. AND the process of Mean Reversion works, then can we profit on a risk-adjusted basis? At the end of this course, we should be able to answer that question. Any one of our investments may go to $0.00 (What did Buffett say, “Rule 1: Don’t lose money and never forget rule 1.” Out of 20 mispriced opportunities, we may have three go to zero, two or three drop 50% and stay there, but 14 rise and provide us with an adequate return.
See full PDF below.