Speculators and unsuccessful investors

• Mark Twain: there are two times in a man’s life when they shouldn’t speculate: when he can’t afford it and when he can.
• There are three ways investors make money:

1. From free cash flow generated by the underlying business, which will translate into a higher share price or distributed as dividends.
2. From an increase in the multiple that investors are willing to pay.
3. Or by a narrowing of the gap between share price and underlying business value.

• For still another example of speculation on Wall Street, consider the US government bond market in which traders buy and sell billions of dollars’ worth of thirty-year US Treasury bonds every day. The average holding period of US Treasury bonds with maturities of ten years or more is only twenty days. Thirty year bonds are prized for their liquidity, and used to speculate on short-term interest rate movements.
• ‍Investment success requires an appropriate mind-set. If you participate in financial markets, it’s crucial to do so as an investor, not as a speculator, and be certain that you understand the difference. Investors are able to distinguish Pepsico from Picasso and understand the difference between an investment and a collectible. When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high.
• Don’t confuse the real success of an investment with its mirror of success in the stock market. 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. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor.
• Story of yield pigs in the 1980s: Early in the decade, abnormally high US treasury yields got investors used to high nominal returns. When rates began to fall, investors kept seeking high current yields, often to their detriment by sacrificing credit quality and other fundamentals. Wall Street, obviously, also obliged by creating products to satisfy demand. Some investors, fixated on current return, reach for yield not with a new Wall Street product, but a very old one: common stocks. Finding bond yields unacceptably low, they pour money into stocks at the worst imaginable times. These investors fail to consider that bond yields are public information, well known to stock investors who incorporate the current level of interest rates into share prices. When bond yields are low, share prices are likely to be high.

The nature of Wall Street works against investors

• Wall Street has a bullish bias.

1. Firms can do more underwriting in rising markets.
2. Brokers do more business and have happier customers in rising markets.
3. Analysts are reluctant to say negative things about the companies they follow, and prefer to issue buy rather than sell recommendations.
4. Investors prefer rising to falling markets.
5. Regulators prefer orderly, rising markets too and they’ve devised various mechanisms to help; mutual funds can’t short sell, and circuit breakers have been introduced to stop markets falling heavily.

• The result…markets can stay overvalued for longer. Correcting a market overvaluation is more difficult than remedying an undervalued condition. With an undervalued stock, a value investor can purchase more and more shares until control is achieved. By contrast, overvalued markets are not easily corrected – short selling is not an effective antidote. And overvaluation is not always apparent to investors. Since prices reflect investors’ perceptions of reality and not necessarily reality itself, overvaluation may persist for a long time.

The institutional performance derby: the client is the loser

• Institutional investors dominate the market. Understanding their behaviour is useful to understand security prices.
• Good description of operating leverage, as it applies to investment firms: Once an investment management business becomes highly profitable, it’s likely to remain that way so long as clients do not depart in large numbers. Management fees paid by new clients constitute almost pure profit. Similarly, lost fees resulting from client departures affect profitability nearly dollar for dollar, since there are few variable costs to be cut in order to offset lost revenues.
• ‍Incentives: managers should invest their own money in their products. In the building practices of ancient Rome, when scaffolding was removed from a completed arch, the Roman engineer stood beneath. Money managers who invested their own assets in parallel with clients would quickly abandon their relative-performance orientation. Intellectual honesty would be restored.
• ‍The problem with “Remain fully invested at all times.” The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock picking, not market timing; they believe that their clients have made the market timing decision and pay them to fully invest all funds under their management. Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost-foregoing the next good opportunity to invest-and the risk of appreciable loss. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.
• “Portfolio insurance had lured people who were not comfortable with the risk of stocks into buying and holding them”. Monday 19th, 1987, after a share market decline the previous week billions and billions of dollars’ worth of stock index futures were dumped in relentless waves by portfolio insurers. This selling drove the futures as much as 10% below stock prices, creating an attractive opportunity for arbitrageurs to buy futures and sell stocks. This selling drove share prices even lower, triggering more sales of futures by hapless portfolio insurers. The notion that you could escape downside risk by selling futures was discredited in a couple of hours. An apparently conservative strategy designed to prevent loss played an important role in the worst debacle in recent financial history.
• ‍Related issue with indexing small cap markets. Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalisation-stock indexers receive more funds, their buying will push prices higher, when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes.
• ‍For similar reasons, Seth Klarman thought indexing would be a fad: I believe that indexing will turn out to be just another Wall Street fad. Investors must try to understand the institutional investment mentality for two reasons:

1. ‍Institutions dominate trading; investors who are ignorant of institutional behaviour are likely to be periodically trampled.
2. Ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by investment elephants can be rewarding.

The myths and misconceptions of junk bonds in the 1980s

• The dangers of zero-coupon or payment in kind bonds – Calling junk zero-coupon and PIK securities bonds didn’t give them the same risk and return characteristics as other bonds, but it did make them easier to sell to investors. Historically, investors in bonds have enjoyed a presumption of solvency, safety, and even seniority. A junk zero-coupon bond, however, is a gamble; no cash is paid until maturity, at which point it either pays or defaults. Many buyers of zero-coupon or PIK junk bonds who believed that they were locking in attractive yield to maturity turned out to have gambled and lost. Most junk zero-coupon and PIK instruments more closely resembled options on a future improvement in business results than fixed and secure claims against the current value of a company.
• ‍As investors sought to analyse free cash flow to understand whether debts were serviceable, they begun to rely on a single number for this; EBITDA. The problem:

1. Depreciation is a non cash expense that reduces net profits but not cash. Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment. Capital expenditures, therefore, are a direct offset to depreciation allowances. The timing may differ, but when a company needs to replace equipment, it needs cash.
2. Adding depreciation back to earnings without subtracting capital expenditures is misleading because the company will need that cash in future to keep its business alive.
3. On the other side – if capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.
4. Karman: “It’s not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow.”

Defining Your Investment Goals

• Avoiding loss should be the primary goal of every investor. This doesn’t mean investors should never incur the risk of any loss at all. Rather, over several years an investment portfolio shouldn’t be exposed to appreciable loss of principle. But loss avoidance is at odds with most conventional wisdom, like:

1. Risk doesn’t come from owning stocks, but not owning them.
2. Stay fully invested.
3. Risk avoidance is incompatible with investment returns.

• Perseverance is so important for compounding. And focusing on downsides is so important for compounding. An investor who earns 16% a year for 10 years will have more money than an investor who earns 20% for 9 years and then loses 15% in the 10th year. Most investment approaches don’t focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that Klarman knows does: value investing.

Value investing: the importance of a margin of safety

• The greatest challenge for a value investor is maintaining the required discipline. Buffett’s baseball analogy – patience and understanding: A long-term oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results.
• ‍An investment must be good absolute value – discount from underlying worth – but also must be the best absolute value from those available. It’s a dual discipline. A pitch must not only be in the strike zone, it must be in his “sweet spot”. There may be times when the investor does not lift the bat from his shoulder; the cheapest security in an overvalued market may still be overvalued. An investment must be purchased at a discount from underlying worth. This makes it good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. This dual discipline compounds the difficulty of the investment task.

• Investors should never be afraid to re-examine current holdings as new opportunities appear, even if that means realising losses on the sale of current holdings.
• There are no certainties about investments. Three ways to respond to the possibility that business value may decline.

1. Valuation should always be performed conservatively, giving considerable weight to worst case liquidation value and other methods.
2. If you fear deflation, can demand a greater than usual discount between price and underlying value – to make new investments and hold existing ones.
3. Think harder about your time frame and the presence of a catalyst for the realisation of underlying value.

• Margin of safety - What does it mean? Include intangible assets in business value? Even among value investors there is ongoing disagreement concerning the appropriate margin of safety. Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets—broadcast licenses or soft-drink formulas, for example—which have a history of growing in value without any investment being required to maintain them. Virtually all cash flow generated is free cash flow.
• ‍The problem with intangible assets, I believe, is that they hold little or no margin of safety. The most valuable assets of Dr Pepper/ Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavors. It is these intangible assets that cause Dr Pepper/ Seven-Up, Inc., to be valued at a high multiple of tangible book value. If something goes wrong—tastes change or a competitor makes inroads—the margin of safety is quite low.
• ‍Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated.
• ‍How do you achieve enough margin of safety?

1. ‍Always buy at a significant discount to underlying business value and give more weight to tangible assets.
2. Replace current holdings as better bargains come along
3. Sell when the market price reflects its underlying value
4. Hold cash if necessary
5. Pay attention to why your holdings are undervalued
6. Look for catalysts
7. Give preference to good managements with stakes in the Haines
8. Diversify and hedge when it’s financially attractive to do so

• Value investing is the antithesis of efficient markets. Klarman believes markets are weak form efficient at best. They stray from underlying value for a number of reasons, mostly temporarily, but it can be for prolonged periods. It’s very important, therefore, to consider why your investment does not reflect underlying business value.
• ‍Summary of value investing: Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgement to know when it’s time to swing. Value investors are not super sophisticated analytical wizards…The hard part is discipline, patience, and judgement.

At the root of a value investment philosophy

• Three central elements of value investing:

1. Bottom up strategy
2. Absolute performance orientated
3. Risk averse approach

Bottom up investing

• The difficulty of top down investing:
• A top-down investor must be correct on the big picture (e.g., are we entering an unprecedented era of world peace and stability?), correct in drawing conclusions from that (e.g., is German reunification bullish or bearish for German interest rates and the value of the deutsche mark), correct in applying those conclusions to attractive areas of investment (e.g., buy German bonds, buy the stocks of U.S. companies with multinational presence), correct in the specific securities purchased (e.g., buy the ten-year German government bond, buy Coca-Cola), and, finally, be early in buying these securities.
• The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing. It is not an attractive game for risk-averse investors.
• There is no margin of safety in top-down investing. Top down investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision.
• Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company’s current price.

Absolute vs Relative performance

• Absolute-performance-oriented investors usually take a longer term perspective than relative-performance-oriented investors.
• A Relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular.

Risk and return

• Risk and return, contrary to popular teaching (like in the CAPM), are not always positively correlated. It’s only true of efficient markets. But in real markets, you can find high risk investments that provide a low return and low risk investments that provide a high return. In inefficient markets it’s possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyse, or when investors buy and sell for reasons unrelated to value.
• Therefore, you have to assess risk and return independently: In point of fact, greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.
• ‍Risk can’t be known after the event. It can’t be known before. And it can’t be reduced to a single number. This is all you can do to manage risk:

1. Diversify adequately.
2. Hedge when appropriate
3. 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.
• Problems with metrics like beta:

1. I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security.
2. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.
3. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share.
4. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value.
5. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment’s volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it.
6. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.

• Conclusion. The primary goal of a value investor is to avoid losing money. Three elements of a value-investment strategy make achievement of that goal possible.

1. A bottom up approach, searching for low-risk bargains one at a time through fundamental analysis.
2. An absolute performance orientation.
3. Paying careful attention to risk – the probability and amount of loss due to permanent value impairments – will help investors avoid losing money.

The art of business valuation

• To buy at a discount from underlying value, you have to first assess business value. Only three methods are useful.

1. Analysis of going-concern value, known as NPV analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. A frequently used but flawed shortcut method of valuing a going concern is known as private-market value.
2. ‍Liquidation value. The expected proceeds if a company were to be dismantled and the assets sold off.
3. Stock market value. An estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

• None of these methods of valuation are perfect but no better methods exist.