Value Investing

Seth Klarman – Value Investing Is A Large-Scale Arbitrage Between Security Prices And Underlying Business Value

The one book that all investors should read is Margin of Safety, by Seth Klarman. A new copy of Klarman’s book is going to set you back around $1000 on Amazon and used copies can be bought for around $750. But it’s money well spent if you wish to be a successful value investor.

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There’s a great piece in the book where Klarman illustrates how value investing is a large-scale arbitrage between security prices and underlying business value. He also explains some of the reasons why the gap narrows between price and value. Klarman concludes the chapter with his thoughts on why value investing is simple but difficult to implement for most investors. Here’s an excerpt from the book:

A central tenet of value investing is that over time the general tendency is for underlying value either to be reflected in securities prices or otherwise realized by shareholders. This does not mean that in the future stock prices will exactly equal underlying value. Some securities are always moving away from underlying value, while others are moving closer, and any given security is likely to be both undervalued and overvalued as well as fairly valued within its lifetime. The long-term expectation, however, is for the prices of securities to move toward underlying value.

Of course, securities are rarely priced in complete disregard of underlying value. Many of the forces that cause securities prices to depart from underlying value are temporary. In addition, there are a number of forces that help bring security prices into line with underlying value. Management prerogatives such as share issuance or repurchase, subsidiary spinoffs, recapitalizations, and, as a last resort, liquidation or sale of the business all can serve to narrow the gap between price and value. External forces such as hostile takeovers and proxy fights may also serve as catalysts to correct price/value disparities.

In a sense, value investing is a large-scale arbitrage between security prices and underlying business value. Arbitrage is a means of exploiting price differentials between markets.

If gold sells for $400 per ounce in the U.S. and 260 pounds per ounce in the U.K. and the current exchange rate is $1.50 to the pound, an arbitrageur would convert $390 into pounds, purchase an ounce of gold in the U.K. and simultaneously sell it in the U.S., making a $10 profit less any transaction costs. Unlike classic arbitrage, however, value investing is not risk-free; profits are neither instantaneous nor certain.

Value arbitrage can occasionally be fairly simple. When a closed-end mutual fund trades at a significant discount to underlying value, for example, a majority of shareholders can force it to become open-ended (whereby shares can be redeemed at net asset value) or to liquidate, delivering underlying value directly to shareholders. The open-ending or liquidation of a closed-end fund is one of the purest examples of value arbitrage.

The arbitrage profit from purchasing the undervalued stock of an ongoing business can be more difficult to realize. The degree of difficulty in a given instance depends, among other things, on the magnitude of the gap between price and value, the extent to which management is entrenched, the identity and ownership position of the major shareholders, and the availability of credit in the economy for corporate takeover activity.

Conclusion

Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

Article by Johnny Hopkins, The Acquirer's Multiple