Value Tripod – Fundamentals Of Value Investing by Joao Alves – Ahead Of The Crowd
Much has and will been written about the anatomy of value investing. Anyone who has studied and practiced the discipline knows that whilst clear, value investing is far from easy. Thinking otherwise makes for a mechanical and myopic approach.
Continued from part one... Q1 hedge fund letters, conference, scoops etc Abrams and his team want to understand the fundamental economics of every opportunity because, "It is easy to tell what has been, and it is easy to tell what is today, but the biggest deal for the investor is to . . . SORRY! Read More
Value investing, in its core, is a philosophy. An investment process follows, and may take many forms. This dichotomous nature of the practice is a complex one. On the one hand, the mandate that governs this investment approach is clear and logical. On the other, the work required to apply it can be complex and bewildering. So how does one reconcile all these paradoxical elements in order to fully appreciate the universality of value investing and to apply it successfully?
In order to achieve maximum clarity in my thinking, I decided to break down the value philosophy into its three fundamental elements. These are: the belief on market inefficiency characterized by Benjamin Graham’s “Mr. Market” allegory; the focus on economic moats, meaning a company’s competitive advantage; and finally, the concept of margin of safety, which protects an investment from the inherent uncertainty of time. I believe all three elements are necessary to increase the odds of an investor outperforming over time.
Value Investing – Mr. Market
Source: Euclidean Technologies Management
‘Mr. Market’ represents the argument in favor of the existence of pockets of inefficiency in financial markets. The basic lesson from this allegory is for an investor never to confuse prices with value. Graham states that although there might be days when Mr. Market gives all the right prices – the true prices reflecting the value of the underlying asset – there will be days when emotion takes over and Mr. Market’s reason will go out the window. As all humans, Mr. Market will feel euphoric at times, and depressed at others. After all, what is the ‘Market’ if not a collection of human attributes and action, all prone to behavioral biases? Bottom line, these inevitable moments of irrationality provide inefficiencies where the market price of a security doesn’t align with the intrinsic value of its underlying business. This signals an opportunity.
In the short run, Graham describes the market as a sentiment driven popularity contest. Circumstantial factors like news, earnings and alike, significantly affect a company’s stock price. However, in the long run, the market turns out to be an objective “weighing machine”, where such factors have no effect at all in a company’s ability to generate value. Over time, the true economics of the business will be displayed by its financial performance, and thus the price will tend to its intrinsic value.
As Graham articulates so well, the element that allows one to observe this in real time is the fact that the market is there to serve the investor. Warren Buffett thoughtfully adds that, “Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.”
Therefore, what Graham teaches is that Mr. Market should never dictate an investor’s course of action. It should be a model to use in order to see beyond the numbing sea of data out there; an instrument to mitigate our biological urges to give in to emotional decision-making and thus, to ensure patience and reason in the face of an uncertain future.
Value investing began with the notion of seeking to pay a price for a business that was less than its true value. Given the lack of net nets stocks nowadays (securities trading at a discount to their liquidation value, calculated as current assets minus total liabilities, which Graham sought to exploit through value investing), the philosophy has since evolved to include the element of growth, where looking at the price alone is not enough.
A “moat” is a sustainable competitive advantage that the company enjoys. Note the key word sustainable. The idea is that an investor wants a company where its competitive position and its profits are independent from economic and business cyclicality as well as from the innate competitive forces of capitalism. The most powerful moats have been described to be network effects, economies of scale, switching cost and consumer preferences. These four advantages are sustainable because they ensure customer captivity or cost reductions, which significantly increases barriers to entry and allows for pricing power, translating into consistent profits.
It’s agreed that the key point in any successful investment is the price paid. However, for that to produce returns, the value of the underlying business must grow and be recognized. This result is more likely guaranteed by an economic moat, which allows an investor to know firstly, whether the business may be safeguarded against unexpected events, and secondly if its assets and operations will growth sufficiently such that the price paid by the investors turns out to be a bargain.
This also explains the reason why the mindset of a value investor must mirror that of the owner of the business. The focus in an investment should lie on the long-term dependability in the growth prospects of the business that underlies the security being purchased.
Margin of Safety
The concept of margin of safety is an elegant one because it connects the Mr. Market realization to the analysis of a company’s economic moats, simultaneously protecting investors from inevitable vicissitudes of sentiment and providing an objective assessment of the asymmetric potential of the bet. This allows for long-term confidence in the investment.
Introduced by Graham in The Intelligent Investor, the margin of safety is defined as the difference between an asset’s intrinsic value and its current market price.
Seth Klarman takes this concept and articulates it in great detail in his famous and rare book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. This was the book that depicted Klarman’s clarity and depth of thinking, which coupled with his stellar returns, made him into an icon of value investing.
His take on the margin of safety is astutely described in the following quote: “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.”
An investment’s margin of safety is found in the company’s balance sheet. The key, as Graham describes, is “buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles”. The assessment is defensive in nature, emphasizing on conservative estimations, which test whether the underlying business can endure unpredictable and intense price fluctuations.
A Short Consolidation
In his 1996 Letter to Shareholders, Buffett states that in order to be successful at investing, “investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.” The former is conceptualized through the concept of margin of safety (business valuation versus market price), while the latter is conceptualized through the allegory of Mr. Market (logic behind market inefficiency).
However, price-awareness alone does not guarantee future profits. Some securities are cheap for a reason; their underlying business may be failing, their business model may have become obsolete, or perhaps their management team is fraudulent. An economic moat adds to the likelihood of a successful investment, as it safeguards the dependability and sustainability of the company’s earnings and as a result, its future.
Therefore, an investment can only yield outperforming results over time if a mix is achieved between; (i) the defensive nature of the margin of safety, (ii) the exploitative urge and patience intended to be instilled by the Mr. Market realization, and (iii) the growth variable added by the characteristics of the business that protect its competitive position and catalyzes its earnings outlook, which is the economic moat.
My Final Remark
Provided that how one understands the complex principles of the theory of investment value depends on personality, I believe that attempts at organizing the elements of the discipline in different ways yield considerable results in increasing one’s clarity of thinking and their ability to invest practically. This is simply my attempt. I hope this to spark creativity and flexibility in one’s approach to constructing an investment process based on the value philosophy, which may increase an investor’s chances of transcending the commonality of markets.