the art of value investing...joel greenblatt. mutual fund luminaries including marty whitman, mason...
TRANSCRIPT
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Contents
Cover
Series
TitlePage
Copyright
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Introduction
Chapter1:“AllSensibleInvestingIsValueInvesting”
WHATITMEANSTOBEAVALUEINVESTORDOESQUALITY
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MATTER?THEVALUEOFGROWTHTHEVALUEMINDSET
PartOne:FieldofPlay
Chapter2:Circleof
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CompetenceTHERIGHTSIZEINDUSTRYPREFERENCEWHEREINTHEWORLD?
Chapter3:DeficientMarketHypothesis
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THEHUMANELEMENTIT'SAMATTEROFTIME
Chapter4:FertileGround
INSEARCHOFUNCERTAINTYSPECIAL
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SITUATIONSOPERATINGTURNAROUNDS
Chapter5:GeneratingIdeas
BEHINDTHESCREENFOLLOWTHELEAD
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RELIABLESOURCES
PartTwo:BuildingtheCase
Chapter6:CuttingThroughtheNoise
SECOND-
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LEVELTHINKINGMACROVERSUSMICROBUSINESSFIRSTWHATQUALITYMEANS
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CRUNCHINGTHENUMBERSWHATCOULDGOWRONG?FROMTHETOPCATALYSTSGETTINGITDONEORGANIZINGPRINCIPLES
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Chapter7:GettingtoYes
CASH(FLOW)ISKINGMULTIPLEANGLESTHEINFORMEDBUYERMODEL
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BEHAVIORPLAYINGTHEODDSTHEORIESOFRELATIVITYPULLINGTHETRIGGER
PartThree:
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ActiveManagement
Chapter8:ThePortfolio
CONCENTRATIONVERSUSDIVERSIFICATIONTHESIZETHAT
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FITSCOGNIZANCEOFCORRELATION
Chapter9:PlayingtheHand
TRADINGMENTALITYDEALINGWITH
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ADVERSITYTAKINGASTANDATTRACTINGACTIVISTS'ATTENTION
Chapter10:GuardingAgainstRisk
MARGINOF
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SAFETYBUILDINGAPOSITIONCASHMANAGEMENTMIDASTOUCHHEDGINGBETS
Chapter11:MakingtheSale
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WHYTOSELLSELLINGBYTHENUMBERSGETTINGTHETIMINGRIGHTSALEPROCESS
PartFour:OfSoundMind
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Chapter12:OfSoundMind
COMPETITIVESPIRITINDEPENDENTTHOUGHTPERPETUALSTUDENTTOERRISHUMAN
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BEEVERSOHUMBLE
TheFinalWord
AbouttheAuthors
Index
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Cover image: ©iStockphoto.com/CandiceCusackCoverdesign:Leiva-SposatoCopyright © 2013 by ValueInvestor Media, Inc. Allrightsreserved.Published by John Wiley &Sons, Inc., Hoboken, NewJersey.Published simultaneously inCanada.
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Introduction
When we launched thenewsletter Value InvestorInsight in early 2005, ourmotivationwasnottotoutthe“10BestStockstoBuyNow”or peddle a proprietarysystem that would “TripleYourMoneyinSixMonths!”Primarily through two in-
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depth interviews with highlysuccessful money managers,ourgoals foreach issuehavebeen to deliver not onlytimely investment ideas, butalso timeless wisdom aboutthecraftofinvesting.Tothatend, our Value InvestorInsightinterviewsexplorethefull spectrum of stockinvesting: from thedefinitionof an underlying philosophy,to the identification of
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potential ideas, the researchand analytical process, thediscipline around buying andselling, all aspects ofportfolio management and,maybe the most important,keeping emotion andcommon behavioral biasesfrom ruining the best effortsofalloftheabove.As befits the title of our
newsletter,we'reunrestrainedproponentsofthecorevalue-
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investing philosophy firstespoused by BenjaminGrahamandthenembellishedand popularized by WarrenBuffett. Value investingmeans different things todifferentpeople(moreonthatlater), but value investors'core belief is that equitymarketsregularlyoffer—foravariety of different butpredictable reasons—opportunitiestobuystakesin
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companies at significantdiscounts to conservativeestimates of what thosebusinessesareactuallyworth.Ifyoucanconsistentlygetthevalue of the underlyingbusinesses right, pay deepdiscounts to those values inbuyingthecompanies'stocks,andmaintainyour convictionand discipline whileconventional wisdomregularly goes against you,
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youcanbeatthemarket.While the core precepts of
value investing strike us aseminently sound, age andexperience have alsomade itequally clear that, likefingerprints, no two value-investing strategies areexactly alike. So manyelements make up a givenstrategyanditsexecutionthatwhen combined withinevitable differences in
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judgment, it's perfectlynormal for equally talentedandaccomplishedinvestorstoassess the landscape ofinvestment opportunities or aspecific idea and come todiametrically opposedconclusions. That's whatmakes investing—andmaking judgments aboutinvestors—so difficult . . .andendlesslyfascinating.As encouraging as it may
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be that there are a multitudeof paths to investmentsuccess,thatinnowayarguesfortryingtopursueseveralatthe same time. The bestinvestors, in our experience,can articulate in a clear andfocused way what they'relooking for, why they'relooking for it and wherethey're trying to find it.Theyhave a well-defined andconsistently applied process
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for research and analysis.They follow specificdisciplines for buying, forselling, for diversification,and for managing risk. Theyare well-versed in thebehavioraltrapsinvestorscanfall into and take concretesteps toavoid them.Obviousas that all should be, we'reconstantly surprised by thenumber of professionalmoney managers who can't
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credibly argue why and howtheyexpecttooutperform.Our goal with The Art of
Value Investing is to offer acomprehensivesetofanswersto the questions every equitymoney manager should havethought through clearlybefore holding himself orherself out as a worthysteward of other people'smoney. Because there is notjust one credible answer to
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eachofthesequestions,we'veprovided a full range ofpotential answers and thejustifications for each. Whatmarket inefficiencies will Itry to exploit? How will Igenerate ideas?Whatwill bemy geographic focus? WhatanalyticaledgewillIhopetohave? What valuationmethodologies will I use?What time horizon will Itypicallyemploy?Howmany
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stocks will I own? Howspecifically will I decide tobuyorsell?WillIhedge,andhow? How will I keep myemotions from getting thebestofme?We'vedelegatedthetaskof
providing answers to suchquestions to the experts: themarket-beating moneymanagers who have gracedthe pages of Value InvestorInsight. Hedge-fund
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superstars such as JulianRobertson, Seth Klarman,Lee Cooperman, DavidEinhorn, Bill Ackman andJoel Greenblatt. Mutual fundluminaries including MartyWhitman, Mason Hawkins,Jean-Marie Eveillard, BillNygrenandBruceBerkowitz.Lower profile but no lessaccomplished moneymanagers such as MaverickCapital's Lee Ainslie,
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Highfields Capital's JonJacobson, Ralph Whitworthof Relational Investors, andJeffrey Ubben of ValueActCapital. We hope to provideuseful context andorganization to thediscussion,butwe leave it tothese superior investors anddozens more like them todescribe how they practicetheircraftandwhy.Wecan'timagine more credible
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sources of information andinsight.We should emphasize that
our goal is not to present asingleanswertoanystrategicquestion an investor faces.Any investor's givenperformance is a function ofthousands of individualdecisions about the strategyhe or she employs and howit's executed over time. Oneinvestor may invest only in
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large-cap stocks, whileanother may never touchthem. One may considerspending time withmanagement to be the mostimportant component ofresearch, while another mayfind it a complete waste oftime. One may specialize inenergy stocks, while anotheravoids them like the plague.What we will do is presentthe conclusions that a set of
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uniquely qualified investorshave reached on a widevarietyofsubjects,aswellastheir explanations for whythey've chosen the strategyand methods they have.While their conclusions willfrequentlydiffer,wehopethediversity of opinion helpsinform the decisions youultimately will have tomakeasaninvestor.WhoshouldreadTheArtof
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Value Investing? Ouraspiration is for it to be asvital a resource for the just-starting-outinvestorasforthesophisticated professionalone.Theformerareprovideda comprehensive guidebookfor defining a soundinvestmentstrategyfromAtoZ; the latter are providedchallenges to all aspects oftheir existing practice andprovocations to potential
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improvements.We also want the book to
be a must-read for anyinvestor—institutional orindividual—charged withchoosing the best managersfor the money they areallocating to equities.Choosing the right managersfor you consists of knowingall the right questions to askaswellastheanswersworthyof your respect and attention
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—both of which we aim todeliver.Ourorganizingprinciplefor
the content roughly matchesthechronologicalprogressiononewouldfollowindefiningand executing an investmentstrategy. In Chapter 1 weexplore the core principlesinvestors rely on to guidetheir strategies. While thoseprinciplesforalltheinvestorswe hear from fall under the
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value-investingumbrella,thatumbrella covers a diversespectrum of thought andopinion. In thesection“FieldofPlay,”thebestinvestorsinthe business describe howthey define their circle ofcompetence, the types ofsituations and inefficiencieson which they look tocapitalize, and how theygenerate ideas. In the section“Building the Case,” we
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examinehowtopinvestorsgoabout their research, wherethey focus their analyticalefforts, how they valuecompanies, and thedisciplines they follow indeciding what to buy andwhen.Whilemostoftheliterature
on stock investing stops atgetting to the buy decision,the final two sections ofTheArtofValueInvestingaddress
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equally importantcontributors to investmentsuccess. The section titled“Active Management”describesbestpractices inallaspects of portfoliomanagement, includingposition sizing,diversification, responding tochanging circumstances, andthe decision to sell. In thesection“OfSoundMind,”wehear how superior managers
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learn from mistakes, whatmotivatesthem,andhowtheyface the many threats torational thinking thatinvestingservesup.Allofthequotesusedhave
appeared in the pages ofValue Investor Insight, withthe vast majority comingfrom first-person interviewswe have conducted over thepast eight years. In a smallnumber of cases—most
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prominently the timelesswisdom from The BaupostGroup's Seth Klarman andOaktree CapitalManagement'sHowardMarks—certain quotes have comefrom investorcommunications that wereeither publicly available orfor which we were grantedpermission to use. In allcases, we offer our sincerethanks to everyone we've
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interviewed, whosegenerosity in sharing theirexperiences and insights istrulyaninspiration.Thequest forknowledge is
a never-ending process forinvestors and is what helpsseparatethebestfromtherestof the pack. To contribute ineven a modest way to thatlearning process is truly ourhonor.
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JohnHeinsWhitneyTilson
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CHAPTER1
“AllSensibleInvestingIs
ValueInvesting”
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A walk down anysupermarket aisle makes itclear we live in a world ofincreasing productspecialization.Tobreakintoanew market or grab more ofan existing one, companieslaunch a dizzying array ofnew products in ever-more-specific categories. Wantyoursodawithmorecaffeineor less? You've got it. Moresugar? Less sugar? Six
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ounces, 10 ounces, 20ounces?Whateveryoulike.Thistrendhasnotbeenlost
on marketers of investmentvehicles. Specialized mutualfunds and exchange-tradedfunds exist for almost everyimaginable combination ofmanager style, geographicreach, industry sector, andcompany marketcapitalization size. If you'relookingforamid-capgrowth
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fund focused on thecommoditysectorinso-calledBRIC countries (Brazil,Russia, India and China),you'relikelytofindit.We understand the
marketing reality ofspecialization, but we arguethatthemostimportantfactorin judging an investor'sprospectivegainsor losses ishis or her underlyingphilosophy. As you might
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guess from the fact that weco-founded a newslettercalledValueInvestor Insight,we agree 100 percent withBerkshire Hathaway's ViceChairman Charlie Munger,who says simply that “allsensible investing is valueinvesting.”But what exactly does it
mean to be a value investor?At its most basic level itmeansseekingoutstocksthat
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you believe are worthconsiderably more than youhave topayfor them.Butallinvestorstrytodothat.Valueinvesting to us is both amindsetaswellasa rigorousdiscipline, the fundamentalcharacteristicsofwhichwe'vedistilled down to a baker'sdozen.Valueinvestorstypically:Focusonintrinsicvalue—whatacompanyis
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reallyworth—buyingwhenconvincedthereisasubstantialmarginofsafetybetweenthecompany'ssharepriceanditsintrinsicvalueandsellingwhenthemarginofsafetyisgone.Thismeansnottryingtoguesswheretheherdwillsendthestockpricenext.Haveaclearlydefinedsenseofwherethey'll
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prospectforideas,basedontheircompetenceandtheperceivedopportunitysetratherthanartificialstyle-boxlimitations.Pridethemselvesonconductingin-depth,proprietary,andfundamentalresearchandanalysisratherthanrelyingontipsorpayingattentiontovacuous,minute-to-minute,cable-
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news-styleanalysis.Spendfarmoretimeanalyzingandunderstandingmicrofactors,suchasacompany'scompetitiveadvantagesanditsgrowthprospects,insteadoftryingtomakemacrocallsonthingslikeinterestrates,oilprices,andtheeconomy.Understandandprofit
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fromtheconceptthatbusinesscyclesandcompanyperformanceoftenreverttothemean,ratherthanassumingthattheimmediatepastbestinformstheindefinitefuture.Actonlywhenabletodrawconclusionsatvariancetoconventionalwisdom,resultinginbuyingstocksthatare
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out-of-favorratherthanpopular.Conducttheiranalysisandinvestwithamultiyeartimehorizonratherthanfocusingonthemonthorquarterahead.Considertrulygreatinvestmentideastoberare,oftenresultinginportfolioswithfewer,butlarger,positionsthanis
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thenorm.Understandthatbeatingthemarketrequiresassemblingaportfoliothatlooksquitedifferentfromthemarket,notonethathidesbehindthesafetyofclosetindexing.Focusonavoidingpermanentlossesratherthanminimizingtheriskofstock-pricevolatility.Focusonabsolute
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returns,notonrelativeperformanceversusabenchmark.Considerstockinvestingtobeamarathon,withwinnersandlosersamongitspractitionersbestidentifiedoverperiodsofseveralyears,notmonths.Admittheirmistakesandactivelyseektolearnfromthem,ratherthan
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takingcreditonlyforsuccessesandattributingfailurestobadluck.
WHATITMEANSTOBEAVALUEINVESTOR
Elaborating in detail on allaspects of the bare-bones list
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above isessentiallywhat thisbook is about. We begin byturning to the uniquelysuccessful investors we'veprofiledovertheyearsasco-editors of Value InvestorInsight toexaminewhat theyconsider to be the keycomponents of a value-investing philosophy, fromgeneral fundamentalprinciples to the overarchingmindset needed to make it
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work.
***
Ourentireprocessisrootedin Ben Graham's simplephilosophical frameworkfor investing. He believedthere were two values forevery stock, the firstbeingthe current market price,and the second what thesharewouldbeworthifthe
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entire company wereacquired by aknowledgeable buyer or ifthe assets were liquidated,the liabilities paid off andthe proceeds paid tostockholders. He calledthat the intrinsicvalueandarguedthatthetimetobuywaswhentherewasalargespreadbetween thecurrentprice and that value, andthe time to sell was when
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thatspreadwasnarrow.Overtimewe'vedevelopeddifferent ways of applyingthat —by valuing incomestreams rather than justassets, by calculatingprivate market values, byinvesting internationally—buttheessenceofwhatwedohasremainedconsistent.Our work every day isessentially directed atvaluing what businesses
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areworth.—WillBrowne,Tweedy,
BrowneCo.
At the heart of being avalue investor is having acontrarian bent. Beyondthat, though, there aremany different flavors ofvalue investing. TweedyBrowne is a great deep-value investment firm.Chuck Royce at Royce
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Funds is a wonderfulGARP [Growth At aReasonable Price]practitioner—he's focusedon value but definitelydoesn't like to own badcompanies. MasonHawkins at SoutheasternAsset Management andMarty Whitman of ThirdAvenue are orientedtoward stocks trading atsignificantdiscounts tonet
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asset value. Bill Miller isprobably best described asan all-out contrarian. Thefact that all these peoplehave been successfulproves that there's nosingle way to do it. Whatthe market offers up asopportunity is constantlychanging, so being able todeploy a variety ofstrategies as the situationwarrants allows us great
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flexibility to go almostanywhere and never getshut out of the market.That's important becauseour investors don't ask ustomoveinandoutofcashdepending on howovervalued or undervaluedwe think the market is.And frankly, having aneclectic view makesinvesting a lot moreinteresting.
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—PrestonAthey,T.RowePrice
We've found that to earnrepeatable, excellentreturns over time withreasonable risk exposurerequires being able toassign somethingapproximating a fair valueto a business, makingconservative estimates.Then it's a question of
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looking at the price. Ifpriceissignificantlybelowthatfairvalue,you'relikelytohaveagoodoutcomebyinvesting in it. If the priceis significantly above thatfair value, you can makegoodmoneybyshortingit.
—ZekeAshton,CentaurCapital
There'snothingparticularlyearth-shatteringaboutwhat
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we try to do. We believethemarket oftenmispricesstocks due to neglect,emotion, misinterpretationor myopia, so our value-addcomesfrombottom-upstock selection. We'retrying tobuyat lowpricesrelative to our currentestimate of intrinsic valueandwewanttobelievethatintrinsicvaluewillgrow.—SteveMorrow,NewSouth
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Capital
When I got much moreinterested in individualsecurities analysis in theearly 1990s I read aswidely as I could and alightbulb just switchedonwhen I read everythingMarty Whitman wrote. Iwasthinkingitwascriticalto understand the ins andouts of how the stock
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market really worked, buthis basic message was toignore the market, whichwasjustthebazaarthroughwhich you had to maketrades. He was all aboutvaluing what a companywas worth—independentof what the market wassaying it was worth at thetime—and buying whenthemarketwasgivingyoua big discount and selling
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when it was paying you apremium.Asobviousas that sounds,it was very liberating tocome across such astraightforward approach.Using whatever analyticaltools I want, whether it'svaluing net assets,calculating private-marketvalues or discountingfuture cash flows, I canarriveataclearestimateof
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whatacompanyisactuallyworth. From there, theactual buying and sellingdecisionsaren'tthathard.
—JimRoumell,RoumellAssetManagement
I've heard it said manytimes that value investingisnotasmuchaboutdoingsmart things as it is aboutnot doing dumb things.Avoiding mistakes,
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resisting market fads, andfocusing on allocatingcapital into ideas that arehighly likely to producesatisfactoryreturnsandthatoffer a margin of safetyagainst permanent capitalloss – these are thedominant themes of thevalue investing approach.Contrary tohow it sounds,these elements don't makevalue investing easier than
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other approaches. In fact,cultivatingthedisciplinetoavoid unproductivedecisions,refiningthecraftof valuing businesses andassessing risk, anddeveloping the emotionaland mental equilibriumrequired to thinkindependently in a field inwhich there is tremendouspressure to conformrequires constant diligence
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andeffort.—ZekeAshton,Centaur
Capital
Long-term-oriented valueinvestors have greaterscope to produce superiorrisk-adjusted returns whenthe seas are rocky. Thevalidresponsewhenthere'schopistofocusontheenddestination—what valueinvestors call intrinsic
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value—and not worryabout whether the nextwave is going to push theboat up or down. If youdon't invest with a veryclear notion of underlyingvalue, how do you do it?Nothingelsemakessense.Your ability to maintainfocus on the long termcomes from experience.You go through a couplecycles where everybody
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elseisscreamingatyounotto try to catch a fallingknife, and then when youdo so and make somemoney,itdoeswondersforyou...andforyourabilitytodoitnexttime.—HowardMarks,Oaktree
Capital
We make no heroicassumptions in ouranalysis, hoping, instead,
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that by compoundingmultiple conservativeassumptions,wewillcreatesuch a substantial marginof safety that a lot can gowrong without impairingourcapitalmuchorevenatall.Weneverinvestjusttoinvestanddon'tbetblindlyon mean reversion or onhistorical relationshipsholding up. Our settingsare permanently turned to
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“riskoff.”—SethKlarman,TheBaupost
Group
In traditional-value ideaswe're looking for a largediscount toourestimateofvalue based on acompany'snormalearningspower, where normalmeans that generalbusinessactivity isnot toohotandnottoocold.These
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tend to be more average-quality businesses, whichcan get very cheap in thedown part of a cycle orwhen dealing with a self-inflictedproblem.The priority in these ideasis on margin of safety,which we look at in twoprimary ways. The first isby making sure thepotential downside is asmall fraction of the
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upside. That means weavoidstocksthatarecheapon an equity-value basisprimarily because there's amountain of debt. Thesecond important way tohave amargin of safety istohavemorethanonewayto win, through earningsgrowth,multipleexpansionor free options in thebusiness.—LeeAtzil,PennantCapital
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Whenever Ben Grahamwasaskedwhathethoughtwould happen to theeconomy or to companyX's or Y's profits, healways used to deadpan,“The future is uncertain.”That'spreciselywhythere'sa need for a margin ofsafety in investing, whichismorerelevanttodaythanever.
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—Jean-MarieEveillard,FirstEagleFunds
People should be highlyskeptical of anyone's,includingtheirown,abilityto predict the future, andinstead pursue strategiesthat can survive whatevermayoccur.[Nassim]Talebadvises us to be “anti-fragile” – i.e., to embracethose elements that benefit
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from volatility, variability,stressanddisorder.This isexactly what we strive todo.
—SethKlarman,TheBaupostGroup
The person with thehighest probability ofoutperformingover time istheonewhoknowshowtovalue companies and buysat a significant discount
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fromthat.I'veheardfor45years why all these otherthings have become moreimportant. You knowwhat?It'sallcrap.—RobertOlstein,Olstein
CapitalManagement
Much of what we do isfocused on the concept ofmeanreversion.Forawidevariety of inputs, such asP/E ratios, profit margins,
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sales growth and dividendyields, we assumeeverything will end up inseven years at normal.There's obviouslyjudgment involved indefiningwhat'snormal,butwe're pretty faithfulhistorians who are alsotryingtouseourbrainsandtrying desperately not tolose money. For a longtime we used 10-year
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forecasts, but haveconcludedthroughresearchthatsevenyearsisclosertothe average time it takesfor a financial series tomeanrevert.—JeremyGrantham,GMO
Price is perhaps the singlemost important criterion insoundinvestmentdecision-making. Every security orasset is a “buy” at one
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price, a “hold” at a higherprice, anda “sell” at somestillhigherprice.Yetmostinvestors in all assetclasses love simplicity,rosy outlooks, and theprospectofsmoothsailing.They prefer what isperforming well to whathas recently lagged, oftenregardless of price. Theyprefer full buildings andtrophy properties to fixer-
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uppers that need to befilled, even though emptyor unloved buildings maybethefarmorecompelling,and even safer,investments. Becauseinvestors are not usuallypenalized for adhering toconventional practices,doing so is the lessprofessionally riskystrategy, even though itvirtuallyguaranteesagainst
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superiorperformance.—SethKlarman,TheBaupost
Group
IfIhadtoidentifyasinglekey to consistentlysuccessful investing, I'dsay it's “cheapness.”Buying at low pricesrelative to intrinsic value(rigorously andconservatively derived)holds the key to earning
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dependably high returns,limiting risk andminimizing losses. It's notthe only thing thatmatters—obviously—but it'ssomething for which thereis no substitute. Withoutdoing the above,“investing”movescloserto“speculating,” amuch lessdependableactivity.—HowardMarks,Oaktree
Capital
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Whenyoulookbackasfaras 80 years for which wehave data, rather thanmoving about withoutrhymeor reason, the stockmarket methodicallyrewards certain investmentstrategies while punishingothers.There'snoquestionthe value-based strategiesthatworkoverlongperiodsof time don't work all the
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time,buthistoryshowsthatafter what turn out to berelatively brief periodswhen other things seem tobe all that matter, themarket reasserts itspreference for value, oftenwith ferocity. My basicpremise is that given allthat,investorscandomuchbetter than the market ifthey consistently use time-tested strategies that are
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basedonsensible, rational,value-based methods forselectingstocks.—JamesO'Shaughnessy,
O'ShaughnessyAssetManagement
Warren Buffett has madethe point many times thatbeingcontrarianreallyisn'tthefullanswer—it'shavingconviction in your ownopinion and filtering out
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the noise. If the markethappenstoberight,beingacontrarian for the sake ofbeing a contrarian isn't avery good strategy. Youhave tohave thedisciplineto stick to the situationswhere you have an edgeandsitouttherestofthem.—JonJacobson,Highfields
Capital
There isn't really a strong
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value-investing culture inEurope—at least thatoperates the way we do.Mostofthebiginstitutionshere define value in termsofhighdividendyieldsandlow P/E multiples onreported earnings. That'swhy so many of them didpoorly in 2008, becausethey owned too manybanks and cyclicalcompanies.Themajorityof
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European hedge funds aretraders who care littleabout valuation but areinvesting based on short-term news or momentum.Some are very good at it,butthat'snotatallwhatwedo. We tell our investorsthat while they're bettingon our skill in identifyingcorporate assets to investin, in the end, they ownhigh-quality assets. That's
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very different thaninvesting in a tradinghedge fund, where you'reinvesting in the tradingskill of the portfoliomanager. If I have a badday,that'snotgoingtohurtthe future prospects of thecompanies I own. If atraderhasabadday,itcanbeadisaster.
—RichardVogel,AlatusCapital
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In a rising market,everyone makes moneyand a value philosophy isunnecessary. But becausethere is no certain way topredict what the marketwill do, onemust followavalue philosophy at alltimes. By controlling riskand limiting loss throughextensive fundamentalanalysis, strict discipline,
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andendlesspatience,valueinvestors can expect goodresults with limiteddownside.Youmaynotgetrich quick, but you willkeepwhatyouhave,andifthe future of valueinvesting resembles itspast, you are likely to getrich slowly.As investmentstrategies go, this is themost that any reasonableinvestorcanhopefor.
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—SethKlarman,TheBaupostGroup
Do those things as ananalyst that youknowyoucandowell,andonlythosethings. If you can beat themarket by charts, byastrology, or by some rareand valuable gift of yourown, then that's the rowyou should hoe. If you'regood at picking the stocks
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most likely to succeed inthe next twelve months,base your work on theendeavor. If you canforetell the next importantdevelopment in theeconomy, or in thetechnology, or inconsumers' preferences,andgaugeitsconsequencesfor various equity values,then concentrate on thatparticular activity. But in
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each case you must proveto yourself by honest, no-bluffing self-examination,and by continuous testingof performance, that youhave what it takes toproduce worthwhileresults.If you believe—as I havealways believed—that thevalue approach isinherently sound,workable, and profitable,
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thendevoteyourselftothatprinciple. Stick to it, anddon'tbeledastraybyWallStreet's fashions, itsillusions, and its constantchase after the fast dollar.Let me emphasize that itdoes not take a genius orevenasuperiortalenttobesuccessful as a valueanalyst. What it needs is,first, reasonable goodintelligence;second,sound
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principles of operation;third, and most important,firmnessofcharacter.
—BenjaminGraham,CommonSenseInvesting
Consultants in theinvestment world work sohard to pigeonholeinvestors that I think eventhe word “value” ismisconstrued to just meanlow multiples of book
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value or earnings. EvenBen Graham early ontalkedabouthowgrowthisof great value, it's justriskierandmoredifficulttoquantify. I'm alwaysamazed that someonewould say they weren't avalue investor—I wouldn'tadmit itevenifIwasn't. Itjust seems silly to thinkabout investing any otherway.
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—ThomasGayner,MarkelCorp.
DOESQUALITYMATTER?
No less an authority thanWarrenBuffetthasdescribedhis evolution as a valueinvestor from being moreinterested early on in “cigar-
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butt” types of companies—distinguished by little morethan how inexpensive theirstocks were relative to theirtangible assets—to anemphasis on less-cheap, buthigher-quality businesseswith a sustainable ability tocompound shareholder valueover long periods of time.The relative importance oneplaces on business qualityremains a central element of
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justaboutanyvalue-investingapproach.
***
Istartedoutin1974withaBen Graham valuestrategy, which suited mypersonality.Foreightyearsthemarketdidnothing,butit was a great time forstock pickers and valueinvesting, so things went
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very well. Around 1982 ithitmethattherewerealotof lousy stocks in myportfolio and I startedwondering why. While itsounds like an obviousconclusion now, thecommon denominator ofthe losers was that theywere in lousybusinesses. Irealized I should be moreofabusinessanalystthanastockanalyst,meaningthat
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to create value as aninvestor I had to betterunderstandhowcompaniesthemselvescreatedvalue.Imoved more away fromclassical stock metrics ofP/E and book value tobusiness metrics of returnoncapitalandcashflows.
—AndrewPilara,RSInvestments
Value to me often derives
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from competitively strongcompanies in structurallyattractive industriessupported by seculargrowth. In financial termsit'seasytodescribeahigh-quality business. Theygenerate high returns onunlevered capital and highreturns on equity on anafter-tax basis. Theyproduce free cash flow orhave attractive enough
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reinvestment opportunitiesto investcash flowathighreturns.Greatbusinesses areworthmore, so I would ratherown that type of companyatareasonablepricethanamediocre company at areallycheapprice.ButI'vealso learned the hard waynever to disregardvaluation—you can easilyoverpay for even the best
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business.—MorrisMark,MarkAsset
Management
As a value investor, Iwasinitially almost exclusivelyfocusedoncompanieswithgoodbalancesheetssellingat lowvaluationmultiples.There's nothing inherentlywrong with that, but I'velearned from experiencethatwhencheapnessblinds
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you to not-so-hotbusinesses or poormanagement, it's a recipefor disaster. We still onlybuybargains,butwepayalotmoreattentiontothingslikewhetherthecompany'sreturns on capital are asgoodastheyshouldbeandat how adept anddisciplined management isat allocating cash flow.When returns are
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inadequate or capital isallocatedrecklessly,equityvalueisusuallydestroyed.
—DavidHerro,HarrisAssociates
Our view is simply thatsuperior long-terminvestment performancecan be achieved whenfinancially strong,competitively entrenched,well-managed companies
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are bought at pricessignificantly below theirbusiness value and soldwhen they approach thatcorporate worth. Thequantitativepieceofthatisthat we only want to buywhenwecanpayless than60 percent of aconservative appraisal of acompany's value, based onthe present value of futurefree cash flows, current
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liquidation value and/orcomparablesales.
—MasonHawkins,SoutheasternAsset
Management
I began as a traditionalvalue investor in the BenGraham mold, looking fornet-nets [companiestrading for less than theircurrent assets minusliabilities], discounts to
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bookvalueandallofthat.Iwould say, though, that Ihave graduated over timetobemorefocusedonverygood companies selling atfairprices.
—PremWatsa,FairfaxFinancial
I have come to theconclusion, asothershave,that in general you findbetter investments in
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businesses with goodeconomics, seculartailwinds, and sustainablecompetitive advantagesthanyoudointryingtogetone last puff out ofproverbial cigar butts.When everything's out offavor and you can buybusinesses with brightfutures without having topay for that future, that's awonderfulthing.
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—DavidWinters,WintergreenFund
I've learned that to meetmyreturngoalsIcan'thavebiglosers.Soregardlessofhowcheapsomethingisorhowmuchpotentialupsidethere is, that meansavoiding companies thatcan wipe out—with toomuch debt, unprovenbusiness models, secularly
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challenged end markets orno durable competitiveadvantages.
—ZekeAshton,CentaurCapital
What I'm looking for aresteady cash flows,reinvested on owners'behalf by honest and ablemanagement. Steady cashflows come frombusinesses that, for one
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reason or another, enjoythe perception ofindispensability for theirproducts. This perceptionof indispensability oftencomes from a brand, butcan also be from realbarriers to competition. Ifyouhavetheonlyquarryintown, it's hard forcompetitors to ship intoyour market becausetransportation costs are so
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high.—ThomasRusso,Gardner
Russo&Gardner
Forthepast30yearswe'vesort of floated in stylebetween Ben Graham andWarren Buffett. Graham'sapproach is static,quantitative, and focusedon the balance sheet.There's no attempt to lookinto the future and judge
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the more qualitativeaspectsofthebusiness.Buffett'smajorideawastoalso look morequalitatively for those fewbusinesses with apparentlysustainable competitiveadvantages,wheretheoddswere fairly high that thebusiness would be assuccessful ten years fromnowasitistoday.Inthosesituations, one makes
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money not so much fromthe elimination of thediscount to intrinsic value,but more from the growthinthatintrinsicvalue.WhenIstartedoutin1979,both in the U.S. andEurope, there were manyBenGraham-typestockstouncover after the dismalstock performance of the1970s. As we grew andmarkets changed, we've
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movedmore to theBuffettapproach, but not withouttrepidation.Ifoneiswrongin judging a company tohave a sustainablecompetitive advantage, theinvestment results can bedisastrous. With theGrahamapproach,theverylarge discount to staticvalue minimizes that risk.Overall, I'd like to believewe've learned well from
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both Graham and Buffettand thatweownsecuritiesthat would attract each ofthem.
—Jean-MarieEveillard,FirstEagleFunds
Wehavemovedmorefroma pure Benjamin Grahamstyle of value investing toone closer to Phil FisherandWarrenBuffett, in thesense that we're putting
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even more weight on thequality of the business. Idon't know, maybe whenyou're younger you justcare about getting thingsthat are cheap andmakingmoney fast. But as youbecome old you see thatbuying companies withhigh and sustainablereturns on capital atreasonable prices tends toworkalittlebitbetter.
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—FranciscoGarciaParames,BestinverAssetManagement
What we've tried to do ismarry the Graham-and-Dodd type emphasis onmargin of safety with themore modern version ofvalueinvestingthatfocusesonacompany'ssustainableability to generate returnson investedcapital (ROIC)that exceed its cost of
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capital. For ROIC we useearningsbeforeinterestandtaxes, divided by the sumof networking capital andproperty, plant andequipment, less cash. Thatmeasure consistentlyexceeding the cost ofcapitalmeans thenet assetvalueis likelytogrowandthe business can be worthconsiderablymorethanthenetvalueofthoseassets.
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—AriLevy,LakeviewInvestmentGroup
Speakingbroadly,probably10 percent of thebusinesses out there arelousy, such as selling purecommodities where themarginalcostofproductiondrives the pricing andcompaniesfinditveryhardto earn even the cost ofcapital over time. I may
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ownsuchacompany fromtimetotime,butit'srare.At the other end of thespectrum are anothermaybe 10 percent ofbusinesses which are ofexcellentquality.Aperfectexample would be moneymanagement firms, whichin aggregate earn obscenereturnsonequity.We loveto own these types ofcompanies, but the
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opportunities to buy themcheaply are relatively fewandfarbetween.So that leaves us mostoccupiedwith theother80percent, in which there's achanging roster ofwinnersand losers. Those changesin fortunes are typicallytied to cycles and howindividual companies aremanaged, which are thetypes of things we believe
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we can analyze and judge.In a lot of our companies,justgettingbacktoaverageoperating performance canresult in excellentinvestmentresults.—PrestonAthey,T.Rowe
Price
We would love to owngreat businesses as muchas the next guy, but theproblem is finding themat
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the right price. We'reperfectlyhappylookingforthe average company,where we think there'ssomething going onwhichthe market hasn'trecognizedthatcanmakeitbetter thanaverage.You'rerewarded asmuch for thatas for a good companybecomingverygood.Wedomakeeveryefforttounderstand what edge the
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company has in facingcompetitive threats ormaintainingpricingpower.When that edge isn't clear,youhavetobeverycarefulabout the valuation youassign to the earnings andcash flow stream. Butbusiness quality, in and ofitself, isn't paramount toourdecisiontobuy.
—VincentSellecchia,DelafieldFund
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We aren't obsessed withperfectionandquality. I'vemade some very niceinvestments in companiesthat were going fromterrible to bad or bad tofair.We're just looking forthe biggest mismatchbetween value and price—where those occur on thequality scale can changeovertime.
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—CarloCannell,CannellCapital
Everything doesn't have tobe thenextMicrosoft—wemay invest in a companybecause the market thinksit's going to fail, and wedon't.
—LeeAinslie,MaverickCapital
When I talk about the
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companies I invest in,you'll be able to rattle offhundreds of bad thingsaboutthem—butthat'swhythey're cheap! The mostcommon comment I get is“Don't you read thepaper?” Because if youread the paper, there's noway you'd buy thesestocks.They're priced where theyare for good reason, but I
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invest when I believe theconditions that are causingthemtobepricedthatwayare probably notpermanent. By nature, youcan'tbeshort-termorientedwith this investmentphilosophy.Ifyou'regoingto worry about short-termvolatility, you're just notgoingtobeabletobuythecheapest stocks. With thecheapest stocks, the
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outlooksareuncertain.Inmywhole career I haveyet to find the greatbusiness with a wonderfulmanagement team, highmargins, a dominantmarketpositionandall theconditions everybodywants, at a low price. Thestocks of such companiesdon'tsellatalowprice.IfIfind one, I'll cheer, but ithasn'thappenedyet.
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—RichardPzena,PzenaInvestmentManagement
People often say theyemphasize the quality ofmanagement or thecompetitive moat of acompany, but the problemwith some of thosegeneralizations is thatcompanies with thoseattributesareveryoftennotattractively priced. Procter
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& Gamble may today beconsidered one of best-managed companies in theworld, with some of thebest brand franchises andwith very low-risk equity,but if the stock is notattractive at the currentprice, none of the restmatters.—RicDillon,DiamondHill
Investments
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I'm generally not obsessedwith quality. Good assetsbought at the wrong pricecanbeterribleinvestments,just as lousy ones boughtvery cheaply can generateexcellentresults.That anything is attractiveat a price might seemintuitively obvious, butmany investorsconsistently ignore it.People feel better in our
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business when prices aregoing up, so youconsistently see buyerscomeinaftermarketshavebeen good, while peopletend to move to thesidelines and watch whenmarkets are bad. Peopleare, ingeneral,momentuminvestors, which iscompletely at odds withbeing a value investor andwhich can create
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opportunitiesforthosewhoaredisciplinedandpatient.—JonJacobson,Highfields
Capital
THEVALUEOFGROWTH
A corollary issue to businessquality is the emphasis valueinvestors place on a
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company's ability to grow.Distinctions tend to bemadein how heavily weightedgrowthisintheassessmentofvalueandintheconservatismwith which future estimatesare made, but avowed valueinvestors typically resistbeing labeledasunconcernedwith growth in assessing acompany'sintrinsicvalue.
***
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Positioning value versusgrowth sets up a falsecomparison. They are notopposite ends of thespectrum—value investingand momentum investingare at opposite ends. Allelse equal, after a stockprice falls with no changein its estimated value, avalue investor will find itmore attractive. Amomentum investor reacts
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intheoppositeway;apricedecline makes the stockless attractive, and viceversa.A value investor needs tobe able to assess thevalueof many businesscharacteristics, such asbalance sheet strength,cash-generating ability,franchisedurability,andsoon. Growth is also one ofthosefactors.Theabilityto
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grow organically is almostalwaysapositive.Itwouldbe a negative only if thatgrowth required so muchinvestment that it had anegative present value.Thatalmostneverhappens.Ten to 15 years ago,investors were paying averyhighpriceforgrowth.Many stocks traded atbarely double-digit P/Es,but large-cap companies
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that had above-averageexpected growth weretrading at 50 timesearnings and higher. Atthat spread, we believedgrowth was way tooexpensive, and it was aneasy choice to avoid it.More recently, valuationshave compressed,meaningthe price of growth hassharply fallen. When wecan get more growth
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without having to pay forit, the choice againbecomesveryeasy.I see value investing asapplying a consistentdiscipline to a changingmarketplace. As the priceinvestors pay for growthbecomes excessive,applying our pricediscipline moves us awayfrom growth. As the pricefor growth declines, our
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disciplinemovesustowardhigher-growthbusinesses.
—BillNygren,HarrisAssociates
I don't get overlyconcerned with how myportfolios are categorized.Our mutual fund wasoriginally called a valuefund, then it was a “core”fund,andnowitshowsupsometimes as a growth
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fund. Through all that, wehaven't changed anythingwe do since day one—thenotion that growth is acreator of value is animportant part of how weinvest.—ChuckAkre,AkreCapital
Management
Peopleoftenmakeitsoundcomplicated, but investingis really all about
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estimatingwhat somethingisworthandthenbuyingitatanattractiveprice.Eventhoughwehaveaclassicalvalueapproach—analyzingstocks as an ownershipstake in a business,calculatingintrinsicvalues,requiring a margin ofsafety—we don't callourselvesvalueinvestorsinany of our marketing orother communications.
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Borrowing from WarrenBuffett, aswesooftendo,weseegrowthandvalueasall part of the sameequation—toseparatethemstrikesusaskindofdumb.There should be fairlybroad agreement thatwhatconstitutes value are acompany's discountedfuture cash flows—thegrowthinthosecashflowsis obviously central to
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figuringthatout.—RicDillon,DiamondHill
Investments
We believe the mostimportantcontributortothelong-term investmentperformance of thecompanies we own isearnings growth, not achange in valuation.Because growth is drivenby earninghigh returns on
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capital and successfullyreinvesting cash flow, wetend to be very long-terminvestors—our averageholding period runs aboutseven years—in order forthis virtuous process tobear fruit. Because of thatorientation,weputprimaryemphasis on marketstructure, the sustainabilityof the business'scompetitiveadvantage,and
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management's track recordin creating shareholdervalueovertime.If you step back and thinkabout the basics of whatwe're doing, we'reinterested in companiesthat are better than theircompetitors and whichhave shown the ability totakethecashtheyearnanddosomethingsmartwithit.There's nothing earth-
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shatteringaboutthat,buttotheextentyoucanapplyit,understand the businessdynamics and not payfoolish prices for things,there's no reason youshouldn't get the attractivelong-term returns webelieve we and ourpredecessors haveproduced.—EricEnde,FirstPacific
Advisors
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When I started in thebusiness and for a longtime,my concept of valuewasabsolutevalueintermsof a price-earnings ratio.But I would say myconcept of value haschanged toamore relativesense of valuation, basedon the expected growthrate applied against theprice of the stock.
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Something trading at 30×earnings that isgrowingat25 percent per year—where Ihaveconfidence itwill grow at that rate forsome time—can be muchcheaper than something at7× earnings growing at 3percent. Some people callthat GARP (Growth-at-a-Reasonable-Price)investing,I'dcallitvalue.Ithinkthat'sjustsemantics.
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We'vealwayshadexcellentanalysts, and a goodanalyst is more adept atmaking judgments ongrowth. That's their job—based on the business andthe company's position init,howfastisthecompanygoing to grow? It's prettyhard to lose if you're righton the growth rates whenthe growth rates are high.In that 30× P/E company
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growing 25 percent peryear, you'll be bailed outpretty quickly because inabout 21/2 years theearnings will double andthemultipleonthatwillgotoonly15×.—JulianRobertson,Tiger
Management
I'mavalueinvestor,whichsays Iwant tobuy50-centdollars,butgivenmyfirm's
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predilectionforservingtheneeds of taxable investors,I also want that dollar totax-efficiently compoundin value over long periodsof time. That means thebusinesses I find attractivemusthavegreatcapacitytoreinvest, which is not allthatcommon.—ThomasRusso,Gardner
Russo&Gardner
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In such a value-focusedworld,weneedtobeallthemore contrarian in ourviews. It also requiresadditional research focuson unique, future-potentialsituations that mighttraditionally have beencalledgrowthideas.Thisisjust a practical response.As defined in classicalGrahamandDoddterms,abargain-basementstockhas
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a market capitalizationlower than its networkingcapital—current assetsminus current liabilities.The approximate numberof companies selling at adiscount to net workingcapitaltodayiszero.—MurrayStahl,Horizon
AssetManagement
Inmyexperience, it'sbeenmore important to be
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involved with a powerfultrend with acceleratingpotentialreturnsthantogettoo hung up on valuation.That's not at all to sayvaluation doesn't matter,but there have been manytimeswhen I've been rightabout the trend but didn'tbuyaleaderbecauseitwas20 percent too expensiveand that turnedout tobeamistake.
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—JohnBurbank,PassportCapital
Tome,investingsuccessis50 percent analyticalability and 50 percentunderstanding and playingoff the market'spsychology.Weareseriousstudentsofmacroeconomicinfluences and trends, andare most interested whenindustrysectorsthatshould
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benefit from majordemographic,technological,oreconomicshiftsareoutoffavor.
—RalphShive,WasatchAdvisors
If you're looking, as weare, for extraordinaryreturns—from companieswhose stocks can go up10×ratherthan2×—it'sfarmore likely to happen
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because the company'searnings turn out to be somuch better than anyoneexpected than because youfound a temporary 50-centdollar.—JohnBurbank,Passport
Capital
I'm looking foropportunities in which Ihave a differentiated viewon forward earnings,
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preferably revenue-driven.Yougenerallymakemoneyin three ways on the longside: your estimates arehigherthantheStreet'sandthe consensus moves toyournumbers,theearningsgrow, or the earningsmultiple expands. By andlarge, themultipleis likelyto expand the most insituationswhererevenueisaccelerating.
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—JedNussdorf,SoapstoneCapital
I tend to look atmultiplesin absolute terms and amquite comfortable with 12to 13× multiples of netincome when I believethere's an opportunity forfastergrowthinearnings—for clearly defined reasons—thanthemarketexpects.Idothinkit'sdangerousto
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lockyourselfintorules.Somany people miss out ongreatopportunitiesbecausea stock only gets within aquarter point of their pricetarget. I try to avoid beingoverlyrigid.—ThomasRusso,Gardner
Russo&Gardner
While price obviouslymatters, if we're right onthebigpicture,Idon'tneed
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a screaming bargain to dowell—compounding valuecancoverupalotofsins.—ThomasGayner,Markel
Corp.
We have learned fromexperiencethatthecredibleexpectation of intrinsic-value growth is a helpfulguard against value traps.We'd rather own a full-priced business with
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potential 15 percent peryear intrinsicvaluegrowththan something at a 30percent discount that hasnogrowth.Themathworksin your favor. Ideally, ofcourse, we're shooting forboth the growth and thediscount.—SteveMorrow,NewSouth
Capital
I've read that the average
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holdingperiodontheNewYork Stock Exchange isninemonths,which Idon'teven consider investing.Oversuchashortperiodoftime you're just betting ontheoveralldirectionof themarket or on the nextquarterly earnings. Itypically don't even makequarterly projections, butget excited when I seeexcellent growth potential
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over time for which I'mpaying next to nothingbecause the market isignoringit.—AaronEdelheit,Sabre
ValueManagement
Many value investors areprimarily focused on priceand valuation, which weobviously think areimportant, but we alsobelieve that when
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constructing a portfolioyoushouldhavecompanieswith promise beyond justgoing fromundervalued tofairlyvalued.Basic-value stocks makeupabout40percentof theportfolio [and] consistentearners, blue-chipcompanies that tend tohavelongrecordsofsteadyorganic revenue and profitgrowthbuteveryonceina
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whilebecomeoutoffavor,also make up around 40percent of the portfolio.Thelastcategorywetrytoown are emergingfranchises, which aretypically youngercompanies with excellentgrowth prospects. Becausethey often have a narrowproduct lineup, they falloutoffavorwhenoneorafew important products
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suffer from inevitablehiccups in growth. I oftensay the only smallcompanywewanttobuyisone that can become a bigcompany—that's whatwe're looking for inemergingfranchises.—WilliamFries,Thornburg
InvestmentManagement
We tend to like equityideas that have almost
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bond-like qualities, wherecashisbeinggeneratedinafairly predictable way andbeing used to pay downdebt or return capital toshareholders throughdividends or stockbuybacks. Companies ingrowth mode, reinvestingall of their cash, are morelikezero-couponbondsandaremoredifficult forus toget our hands around. It's
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not thatwenever invest ingrowth ideas, but it's notourfocus.—MitchellJulis,Canyon
Capital
We expect to generate thevastmajorityofourreturnsnot from thegrowth in thevalue of the business, butfrom the unwinding of thevaluediscount.We'remorethan happy to see growth
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potential andwe recognizehowvaluableitcanbe,buthigher-growth businessestypicallyexposeustomorevaluation risk than we'recomfortablewith.
—DavidSamra,ArtisanPartners
THEVALUE
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MINDSETWhile the success of anyinvestment strategy bearsheavily on the intelligenceand technical skill of itspractitioners, value investorsalsobelieve theircompetitiveadvantage rests upon theuniqueandmultifacetedvaluemindset they possess. It's anattitudeasmuchasastrategy,born more than bred, and
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indispensible to their abilitytooutperformovertime.
***
Starting with the firstrecorded and reliablehistorythatwecanfind—ahistory of thePeloponnesian war by aGreek author namedThucydides—andfollowing through a broad
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array of key historicalglobal crises, you seerecurringaspectsofhumannature that have gottenpeopleintotrouble:hubris,dogma, and haste. Thekeys to our investingapproach are thesymmetrical opposite ofthat: humility, flexibility,andpatience.On the humility side, oneof the things that Jean-
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Marie Eveillard firmlyingrained in the culturehere is that the future isuncertain. That results ininvesting with not only apricemarginof safety, butin companies withconservativebalancesheetsand prudent and provenmanagement teams. If youacknowledge your crystalball is at best foggy, youfollow the advice of Ben
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Grahamandinvesttoavoidthelandmines.In terms of flexibility,we've been willing to beoutofthebiggestsectorsofthemarket,whether itwasJapan in the late 1980s,technology in the late1990sorfinancialsthelate2000s. That wasn'tnecessarily because of anyparticular gift of foresight,but reflected a recognition
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that each of those areasembodied very widelyaccepted and highexpectations. It's painfulandnotsociallyacceptableto be out of the mostrevered sectors of themarket, but those types ofactsofomissionhavebeena key contributor to thestrongperformance.The third thing in termsoftemperament we think we
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valuemorethanmostotherinvestors is patience. Wehave a five-year averageholdingperiod.Particularlyin a volatile market liketoday's,peoplearetryingtozigandzagaheadofeverymarket turn that they'rehoping they can forecastwith scientific precision.We like toplant seedsandthenwatch the trees grow,and our portfolio is often
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kind of a portrait ofinactivity. That's kept usfrom making sharp andsometimes emotionalmoves that we eventuallycometoregret.—MatthewMcLennan,First
EagleFunds
The key to the success ofvalue investing is that it isbasically contrarianinvesting. How can you
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buy something at a valueprice if it's desired by theworld? Investors goout oftheir way to look forcompanies with certaincash flow characteristics,returns on assets that arestable and that haveobjectively verifiabletangible assets that couldbeliquidatedatsomepoint.If that's going to be thefocus for literally
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thousandsoffunds...howcould you possibly haveoutstanding results by justdoingthesamething?—MurrayStahl,Horizon
AssetManagement
It's important to play toyour strengths. As aninvestor, I'm not a home-runhitterandcan'tthinkofalotofsecuritiesonwhichI've made 10 times my
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money. But I also can'tthinkof a lot of securities,post-1970, on which I'velost a meaningful amountof capital. Success ininvesting is not reallymuch more complicatedthanthat.
—SpencerDavidson,GeneralAmericanInvestors
It'shardformostpeopletograspthatagreatcompany
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isnotalwaysagreatstock,andthatagreatstockisnotalways a great company.Value works becauseyou're consistently payinglesstogetmore.Overtimethatworksalotbetterthanpayingmoretogetless.—JamesO'Shaughnessy,
O'ShaughnessyAssetManagement
Going against the grain is
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clearly not for everyone—and it doesn't tend to helpyouinyoursociallife—butto make the really largemoney in investing, youhave to have the guts tomake the bets thateveryone else is afraid tomake.—CarloCannell,Cannell
Capital
Our worst mistakes have
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been far more likely aresult of our being afollower rather than aleader. We've been muchless successful buying intostories that are out therealready than ones thatwe're anticipating inadvance.
—SamIsaly,OrbiMedAdvisors
It's important to remember
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asacontrarianinvestorthatthe consensus is oftenright. My colleagueFrançoisSicartlikestosay,“Just because everyonesays it's raining outside isno reason not to take anumbrella.”Butbecausewebelieve the consensus ispriced into any giveninvestment, going alongwith that is a very hardplace fromwhich tomake
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money.—RobertKleinschmidt,
TocquevilleAssetManagement
Value investors tend tohave a different defaultquestion in looking at apotentialopportunity.Mostinvestment managers ask“Can I own this?”—towhich the answer isgenerally yes. Value
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investors put a differentburden of proof on everyidea by asking, “Whyshould I own this?” Thatdegree of skepticism is avaluabletrait.—JamesMontier,Société
Générale
We do tend to be a littledour at times and wedefinitely take a skepticalview of the facts. Warren
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Buffett once said, “Youpayaveryhighpriceforacheery consensus.” Valueinvestors simply don'tbelieve in cheeryconsensus. That's not acriticism—I'd consider it abadgeofhonor.
—DanielBubis,TetremCapital
Most investors takecomfort from calm,
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steadily rising markets;roiling markets can driveinvestor panic. But theseconventional reactions areinverted. When all feelscalm and prices surge, themarketsmayfeelsafe;but,in fact, they are dangerousbecause few investors arefocusingonrisk.Whenonefeels in the pit of one'sstomach the fear thataccompanies plunging
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market prices, risk-takingbecomes considerably lessrisky,because risk isoftenpricedintoanasset'slowermarket valuation.Investment successrequires standing apartfromthefrenzy—theshort-term, relative performancegame played by mostinvestors.
—SethKlarman,TheBaupostGroup
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Whatyoushoulddoistakea dimviewofwhat's beenappreciating and beinterested in what hasn'tbeen good to you. Youcertainly want tounderstand why any assetclasshasbeengoingdown,but you should celebratethe fact that it has beengetting cheaper. To saypricegoingdownisagood
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reason to look the otherway is like saying you'dnever go shopping whenstoresarerunningsales.—HowardMarks,Oaktree
Capital
We're classic valueinvestors in the sense thatwhensharepricesare low,we think risk is low aswell. Most people canunderstand that in theory
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but don't believe it inpractice and even act as ifit's heresy. It's actuallywhen prices are rising andstocksare convergingwithour share-price targets thatwe find risk far moreuncomfortable.—SarahKetterer,Causeway
Capital
Someone asked me theother day whether
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watching what was goingon [in troubled markets]felt lousy, and of course itdoes.Butyoucanonlybuyquality cheapwhen peopleare afraid. We earn ourkeep much more indifficultmarketsthanwheneverybody's serene andhappy.
—DavidHerro,HarrisAssociates
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I'm perfectly fine if Mr.Market wants to go downanother15to20percent—we'll justbuymore stocks.It'snotduringupyearsthatgreat investment trackrecordsaremade!
—CharlesdeVaulx,InternationalValueAdvisers
The market is extremelynoisy,butyoujustcan'tletthatdistractyoufromyour
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discipline and yourframework.We'vesaidthissince we started out: Themarket is really just apendulum that foreverswings betweenunsustainable optimism,which makes stocks tooexpensive, and unjustifiedpessimism, which makesthem too cheap. All we'retryingtodoiskeepalevelhead, sell to the optimists,
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and buy from thepessimists.—JonathanShapiro,Kovitz
InvestmentGroup
Warren Buffett is rightwhen he says you shouldinvest as if the market isgoing to be closed for thenext five years. Thefundamental principles ofvalue investing, if theymake sense to you, can
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allow you to survive andprosper when everyoneelseisrudderless.Wehavea proven map with whichtonavigate. It soundskindof crazy, but in times ofturmoil in themarket, I'vefelt a sort of serenity inknowing that if I'vecheckedandrecheckedmywork, one plus one stillequals two regardless ofwhere a stock trades right
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afterIbuyit.—SethKlarman,TheBaupost
Group
When you have a modelyou believe in, that you'veused for a long time andwhich is more empiricalthanintuitive,stickingwithit takes the emotion awaywhen markets are good orbad. That's been a centralelementofoursuccess.It's
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the emotional dimensionthat drives people tomakelousy,irrationaldecisions.
—WillBrowne,Tweedy,BrowneCo.
I like to say that changinginvestment styles to thelatest fad produces thesame results as changinglanes during rush-hourtraffic jams: You increasetheriskofanaccidentwith
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little chance of achievingbetter results. Thepsychological pain ofsticking to your guns,though, is tough. Iwas up35percentin1999buthadpeople telling me I didn'thaveenoughtechnologyinmy fund and they weretaking money out. This isnot nuclear physics, but[it's] hard to stick to yourguns when the crowd's
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runningoveryou.Wedon'tbelieve value investing isever out of style—it justdoesn't work all of thetime.—RobertOlstein,Olstein
CapitalManagement
Therealsecrettoinvestingis that there isnosecret toinvesting. Every importantaspect of value investinghasbeenmadeavailableto
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the public many timesover, beginning with thefirst edition of SecurityAnalysis. That so manypeople fail to follow thistimeless and almostfoolproofapproachenablesthose who adopt it toremain successful. Thefoibles of human naturethat result in the masspursuit of instant wealthand effortless gain seem
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certain to be with usforever. So long as peoplesuccumb to this aspect oftheir natures, valueinvestingwill remain, as ithas been for 75 years, asound and low-riskapproach to successfullong-terminvesting.
—SethKlarman,TheBaupostGroup
It is occasionally possible
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for a tortoise, content toassimilate proven insightsofhisbestpredecessors, tooutrun hares which seekoriginalityordon'twish tobe left out of some crowdfolly which ignores thebestworkof thepast.Thishappens as the tortoisestumbles on someparticularly effective wayto apply the best previouswork, or simply avoids
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standardcalamities.Wetrymore to profit by alwaysremembering the obviousthan from grasping theesoteric. It is remarkablehow much long-termadvantage people like ushavegottenbytryingtobeconsistently not stupid,insteadoftryingtobeveryintelligent.—CharlieMunger,Poor
Charlie'sAlmanack
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In a world in which mostinvestors appear interestedin figuring out how tomakemoney every secondandchasetheideadujour,there's also somethingvalidating about themessagethatit'sokaytodonothing and wait foropportunities to presentthemselves or to pay off.That's lonely and contrary
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a lot of the time, butreminding yourself thatthat'swhat it takes isquitehelpful.
—SethKlarman,TheBaupostGroup
One investor who hasgreatlyinfluencedmefroma conceptual standpoint isHoward Marks, theChairman of OaktreeCapital.He's not an equity
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investor, but he describesthis notion of running acore strategy, focused onbeating themarket throughthe accumulation of smallbut high-probabilityadvantages over a longperiod of time. Thealternative,which can alsobe a legitimate strategy, isto swing for the fenceswith the goal of hittingenoughhomerunstodrive
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outstanding performance.The high-probabilityapproachisconsistentwithmypersonality.
—ZekeAshton,CentaurCapital
I feel strongly thatattempting to achieve asuperior long-term recordbystringing togethera runof top-decile years isunlikely to succeed.
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Rather, striving to do alittle better than averageevery year, and throughdiscipline to have highlysuperior relative results inbadtimes,is:(1)lesslikelyto produce extremevolatility; (2) less likely toproducehuge losseswhichcan't be recouped, and (3)most importantly, morelikelytowork.—HowardMarks,Oaktree
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Capital
Oneofthetemptationsofaprofessionalinvestoristhatoneisoftendrawntowardsdifficult analyticalproblemsinsearchofabigpayoff. If anything, thistemptation has beenamplified in recent yearsby the acclaim andfinancial rewards thathaveaccrued to those who end
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up on the right side of abig, dramatic bet – themore complex, the better.The problem is that suchsuccessishardtomaintain,hard to predict, andgenerally creates furtherpressure to find similarlydifficult, large-scalemispricingopportunities toexploit in the future. Suchopportunities may not beavailablemostof the time,
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which may explain whymany of those investorswho get thingsdramatically rightoneyearfind themselves getting itdramatically wrong thenext.Attheendoftheday,being consistently smarterthan the rest of themarketis probably next toimpossibletodo.
—ZekeAshton,CentaurCapital
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I don't think being a valueinvestor is something youcan learn. You can learnhow to be better at it andtheanalyticalsupportforit,but you can't sit there andsay,“I'mgoingtomakeanintellectual decision thatI'm going to become avalue investor.” Mypersonal belief is thatyou're either born as a
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bargain-hunter type oryou're born as a bright-eyedoptimist.Youhavetobe skeptical andpessimistic, and you havetoreallyenjoythebargain-huntingprocess, and ithasto be part of your wholelife. I find that the peoplewhoarethebestatthisarethetypeofpeoplewhoareabsolutelythrilledtofindapair of shoes for $20 that
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they couldhavepaid$150foratadepartmentstore.
—RichardPzena,PzenaInvestmentManagement
Some of the best earlyadvice I got was to forgetall I'd learned in businessschool about efficientmarkets and instead readBen Graham. You eithertaketoitoryoudon't,andIknew right away that this
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washowIwantedtodoit.—PremWatsa,Fairfax
Financial
We consistently articulatetwo goals—to achievepositive returns and tooutperform the market. Ifyou aren't going to makemoney owning our mutualfund, then there's no pointin buying it. And if youaren't going tomakemore
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money than you wouldhave in an index fund,we'renotworthourfees.Attheendof2010Ilookedat the previous decade forthe Oakmark Fund, to seein how many quarters wecouldtellourinvestorsthatwe both made money andthatwemademeaningfullymore—which I defined as100 basis points—than theS&P 500. Of the 40
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quarters, only eightqualifiedaswinners.That'slike hitting .200 inbaseball,justoneoutawayfrom a ticket to the minorleagues.For those 10 years,however,thefundreturned74 percent, versus 15percent in total return forthe S&P 500. So eventhoughweweremostoftenfrustrated because we lost
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money or didn't make asmuch as somebody else,overthatperiodwebeat96percentofcompetingfundsand did more than 400basispointsbetterperyearthanthemarket.Thattomeis kind of the essence ofvalue investing. We oftendon't keep up with strongmarkets,butmakeupforitby losing less duringmarket declines.
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Expectations forcompanies we own aretypically quite low, whichmeans they don't usuallyfall asmuchas themarketdoeswhentimesgettough.Itisalimitedsetofpeoplewho have the personalityand discipline tosuccessfully invest thisway.Iguessthat'swhywecancontinuetoputfoodonthetable.
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—BillNygren,HarrisAssociates
Value investing strategieshaveworked foryearsandeveryone's known aboutthem. They continue towork because it's hard forpeopletodo,for twomainreasons. First, thecompaniesthatshowuponthe screens can be scaryand not doing so well, so
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people find them difficultto buy. Second, there canbeone-, two-or three-yearperiods when a strategylikethisdoesn'twork.Mostpeople aren't capable ofstickingitoutthroughthat.—JoelGreenblatt,Gotham
Capital
Ifyouareavalueinvestor,you'realong-terminvestor.If you are a long-term
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investor, you're not tryingto keep up with abenchmarkonashort-termbasis. To do that, youaccept in advance thatevery now and then youwill lag behind, which isanotherwayof sayingyouwillsuffer.That'sveryhardto accept in advancebecause, the truth is,humannatureshrinksfrompain. That's why not so
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many people invest thisway.But if you believe asstrongly as I do that valueinvesting not only makessense, but that it works,there's really no crediblealternative.
—Jean-MarieEveillard,FirstEagleFunds
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PARTOne
FieldofPlay
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CHAPTER2
CircleofCompetence
In a 1989 Fortune articleprofiling 10 young moneymanagers—under the title
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“Are These the NewWarrenBuffetts?”—MarshallWeinberg, of the brokeragefirmGruntal&Co., recallsadinner in Manhattan he hadwithBuffetthimself:“Hehadan exceptional ham-and-cheesesandwich.Afewdayslater, we were going outagain and he said, ‘Let's gobacktothatrestaurant.'Isaid,‘Butwewere just there,' andhesaid, ‘Precisely.Whytake
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ariskwithanotherplace?Weknow exactly what we'regoingtoget.'AndthatiswhatWarren looks for in stockstoo. He only invests incompanieswheretheoddsaregreat that they will notdisappoint.”This anecdote says a great
deal about a core tenet ofsuccessful investing:combining an understandingof what Buffett calls your
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“circle of competence” withthe discipline to remainwithin itsboundaries.There'scertainly no one right circleof competence to have, norshould it remain static overtime. But when successfulinvestorstalkaboutideasthathave gone awry, one keyreason often cited has beenventuring into an industry,company,ormarket situationwith which they don't have
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experienceordon'tyethaveafullcommand.Enoughcangowrong even when you're inthe center of your circle ofcompetence,whyincreasethechance of mishap byoperatingoutsideofit?Regardlessofhowbroador
narrowtheirfieldofplay,thebest equity investorsareableto articulate clearly wherethey expect to find investingopportunity and why. This
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circle-of-competencedefinition includes thecharacteristics of companiesof interest, with respect tosuch things as their size,where they operategeographically,theirbusinessmodels, and the industry orindustries in which theycompete. It also includes thesituations that the investorhas found can lead topotential share mispricing,
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such as where a company isin its evolution, where anindustry is in its cycle, andwhen a company or industryis likely to be neglected ormisunderstood. All of thisinforms where the investorwill—and won't—look forideas, and the tactics he orsheusestogeneratethem.Inan interview in2009we
asked Julian Robertson, thefounderofTigerManagement
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and one of the mostsuccessful hedge fundmanagers of all time, whatadvice he might have forstudents interested inpursuing an investing career.He spoke about them gettingexperience working with thebest investors possible, andaboutlearningtofocus:A baseball player neverreally gets paid, nomatterhow many homeruns he
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hits or what his battingaverage is, unless he getsto the big leagues. Thenhe's guaranteed tomake alot of money. But in thefundbusinessyoucan findaminor league where youcan hit for a betteraverage, because that'swhatyou'repaidon.IrememberoneofourguystakingusintoKoreaintheearly 1990s, and the
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market was so inefficientthat it was a gold mine ifyou knew what you weredoing. One of our Tigerfunds today focuses ongold—a league that isinhabited by some of thecrazier investors out there—and it just has aphenomenal record. Theyknowmoreaboutgoldthananyone else in the worldand they just kill all the
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rest.My point is that to besuccessful in this business,youdon'thavetobebetterthan everybodyeverywhere, just betterthan everybody in theleague in which you play.It's maybe today moredifficult to find thoseinefficient areas, but it'snotimpossible.This section assembles the
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myriad answers the bestinvestors givewhen asked toexplain where they look foropportunity and to justifywhythey'vechosenthefocusthey have. Again, it'simportant to keep in mindthat there isnonarrowsetofright answers here. Whatmatters is that some level ofclearfocusexistsandthattherationale behind it is sound.From there, it's all about
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execution.
THERIGHTSIZE
One of the most basicdistinctionsinvestorsmakeindefining their field of playconcernscompany size.Howbigacompanyiscansayalotabout its complexity, thesustainability of its business
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model,howactivelyfolloweditis,thevolatilityofitsstockprice, and why it might bemispriced. Practical concernscanobviouslycomeintoplay:Amanagerwith$5billion inassetswill find itmuchmoredifficulttoinvestinmicrocapstocks—where he or shemight have to own 100percent of the company inorder to take a position sizethat is material to his
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portfolio—thanwill someonemanaging $50 million. Butmanagers typically canidentify their sweet spot interms of market cap, or,alternatively, should be ableto explain why they'reagnosticonthepoint.
***
Our strategy from thebeginning has been to
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focus on areas where webelieve we can have someadvantage,wherethereisagreater prevalence ofirrationality and higherlikelihood of mispricedassets. For us, that's notgoing to be investing inMicrosoft or in somequantitative strategyagainst a room full ofGoldman Sachs' PhD'swithCray supercomputers.
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We have to be guerrillainvestors, lying in theweeds and picking offopportunities among theobscureandmundane.That usually means small,ignored companies that noone else is talking about.We'll invest in companieswithup to$1billionor soin market cap, but havebeen most successful inideas that start out in the
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$50millionto$300millionrange. Fewer people arelooking at them and theindustries the companiesare in can be quite stable.Given that, if you find acompany doing well, it'smore likely it can sustainthat advantage over time.We can also take asignificant-enough stake inany company that, ifnecessary,we can have an
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impactonhowit'srun.—JamesVanasek,VNCapital
My basic premise is thatthe efficient marketshypothesis breaks downwhen there is inconsistent,imperfect dissemination ofinformation. Therefore itmakes sense to direct ourattention towards the14,000 or so publiclytraded companies in the
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U.S. for which there islittle or no investmentsponsorshipbyWallStreet,meaning three or fewersell-side analysts whopublishresearch.Money ismade in the dark, not thelight.You'dbeamazedhowlittlecompetitionwehaveinthisneglected universe. It isjustnot in thebest interestof the vastmajority of the
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investing ecosphere tospend 10 minutes on thecompanies we spend ourliveslookingat.IconsidermyselfbetteroffbuyinganindexfundoranETF rather than trying tofigure out how to ownJohnson & Johnson orCoca-Cola or Exxon, veryhigh-quality companieswith dozens of analystsfine-tuning their estimates
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bythepennyeveryweek.IloveCoca-Colaandfinditsfinancial characteristics tobe outstanding, but howcan I have an edge inbuying and selling itsstock?Howcansomethinglikethateverbeafatpitch?Iwouldpointoutthatmostignored companies are notinvestable, either becausethey're not really public orare just complete garbage.
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Butwithinthatfleamarketis where you find thegreatest bargains, so wetroll through it to find thesmall percentage ofcompanies thatare ignoredforimproperreasons.—CarloCannell,Cannell
Capital
I accept the propositionthat public markets aremost of the time efficient
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in pricing large-capcompanies, but I've neverbelieved there wassufficient trading volumeor research coverage ofvery small companies tomake their prices similarlyefficient. So it ought to atleast be theoreticallypossible for an investor inmicrocaps to have aninformational advantage.We focus on companies
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