getting started in value investing chapter 2

8/8/2019 Getting Started in Value Investing Chapter 2

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Getting Started In Value InvestingChapter 2: The Basics of Value Investing: A Few Things You Must Know

All intelligent investing is value investingto acquire more than you are paying for. CharlieMunger

Those who subscribe to the efficient market theory believe that all new information isalready incorporated into a companies stock price because large smart money investors

have already acted and erased any discrepancy between price and value Despite examples like the October 1987 crash and the dot.com bubble efficient market

theory continues to be advocated by many business schools

Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited totheologians. Warren Buffett

Practitioners of the efficient market theory suggest buying index funds and matching themarket returns while eliminating trading costs and research time

Louis Lowenstein wrote a paper titled Searching for Rational Investors in a Perfect Stormwhere he highlighted the markets irrational behavior during the dot.com bubble in 2000

NASDAQ was at 1,200 in April 1997 and rose to 5,000 in March 2000 and then fellback to 1,100 in October 2002

This does not reflect underlying business valuations and represents human emotionat work

He then looks at 10 value oriented mutual funds that averaged 10.82% annualreturns from 1999-2003 when the S&P 500 index was negative

These funds were Clipper Fund, FPA Capital, First Eagle Global, Longleaf Partners,Legg Mason Value, Mutual Beacon, Oak Value, Oakmark Select, Source Capital andTweedy Brown American Value

Lowenstein highlights a August 2000 Fortune article where they selected 10 Stocksto Last the Decade

These stocks were Broadcom, Charles Schwab, Enron, Genetech, Morgan Stanley,Nokia, Nortel Networks, Oracle, Univision and Viacom

These stocks were trading at around a 50 price-to-earnings ratio and subsequentlylost 80% of their value by the end of 2002

Only one of the 10 value funds highlighted owned any of these stocks

The investors explained they felt the securities lacked a margin of safety whichprohibited them from buying

During this period value managers were picking up old economy stocks that no onewanted during the tech boom and patiently waiting for them to rise to more normalvaluations

History has proven that, over time, stock prices, although volatile in the short term,will converge with intrinsic business value. Longleaf Partners 1999 Annual Report

Margin of safety is a critical concept in value investing that is defined as buying a security ata price that is significantly lower than your intrinsic value estimate in order to allow for theinevitable risks of projecting future earnings and cash flow

If you understood a business perfectly and the future of the business, you would need very littlein the way of a margin of safety. So, the more vulnerable the business is, assuming you still want

to invest in it, the larger margin of safety youd need. If youre driving a truck across a bridge

that says it holds 10,000 pounds and youve got a 9,800 pound vehicle, if the bridge is 6 inchesabove the crevice it covers, you may feel okay, but if its over the Grand Canyon, you may feel

you want a little larger margin of safety. . . . Warren Buffett

The author believes that the individual investor has an advantage in beating the market overinstitutional investors because they have three major constraints

1. Short-term time horizon2. Market cap limitations3. Restrictions on sector/geography/cash levels


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Institutional investors are forced to worry about their performance relative to their peersover weekly, monthly and quarterly time intervals

If they underperform their peers they are likely to see assets under management decline Individual investors have the advantage of focusing on absolute returns in comparison to the

S&P 500 over longer time intervals

This gives them the freedom to invest in what looks attractive on a valuation basis andholding for the long term rather than buying what other managers are buying so as not to fallbehind their peers in performance

An irresistible footnote: in 1971, pension fund managers invested a record 122% of net fundsavailable in equitiesat full prices they couldnt buy enough of them. In 1974, after the bottom

had fallen out, they committed a then record low of 21% to stocks. Warren Buffett

Size is another major constraint for institutional investors If an institutional investor has $1 billion under management it makes very little sense to buy

5% of a $200 million market cap company because the manager would only be deploying$10 million of capital

Even if this investment performed extraordinarily it would have very little impact on thefunds returns

As a result large institutional investors are limited to investing in companies with largemarket capitalizations, while the individual investor can focus on a much larger universe of

smaller capitalization companies Institutional investors are also limited by mandates related to sector, geography and cash

levels

A manager with a mandate to invest in technology stocks cant purchase retail stocks even ifthey are extremely cheap

A manager with a mandate in Canadian companies cant purchase U.S. companies even ifthey undervalued

Many institutional investors are also prohibited from holding cash and forced to be fullyinvested at all times

Even if a technology fund manager knows the sector is overvalued he must continue to buyshares at overvalued levels

Mr. Market could be giving away dollar bills for dimes, yet these managers would not bepermitted to buy them

Bens Mr. Market allegory may seem out-of-date in todays investment world, in which mostprofessionals and academicians talk of efficient markets, dynamic hedging and betas. Their

interest in such matters is understandable, since techniques shrouded in mystery clearly have

value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame

and fortune by simply advising Take two aspirins? Warren Buffett

A value investor should not overreact to short term events like economic indicators, ratherhe should focus on the underlying business fundamentals

The value investor should use short term indicators to pick up shares of undervaluedcompanies

Investment managers frantically trade long-term securities on a very short-term basis . . .hundreds of billions of dollars are invested in virtual or complete ignorance of underlying

business fundamentals, often using indexing strategies designed to avoid significant

underperformance at the cost of assured mediocrity. - Seth Klarman, The Baupost Group

During periods of excessive valuations value investors should take advantage of theopportunity to keep assets in cash

It is painful having money in the bank earning about 2%. Our investment philosophy isbimodal; either we invest in high returning opportunities or have the money in the bank or

under our mattresses. - Leucadia National Corporation, Letter from the Chairman and

President, 2005

Key Points


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1. The popular efficient market theory (EMT) is simply, probably wrong.History has shown that markets, at times, are extremely inefficient,especially when it comes to the prices of businesses.

2. The smart money does not follow the crowd, but instead seeks outexceptional stocks selling at bargain prices.

3. The 300 largest institutional investors control more than half of the stockmarkets capitalization. But most underperform the market. This single factshows how individuals using the principles of value investing can, indeed,beat the big mutual funds.

getting started in value investing chapter 2

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