Getting Started In Value Investing

Chapter 2: The Basics of Value Investing: A Few Things You Must Know
• “All intelligent investing is value investing—to acquire more than you are paying for.” – Charlie
Munger
• Those who subscribe to the efficient market theory believe that all new information is
already 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 to
theologians.” – Warren Buffett
• Practitioners of the efficient market theory suggest buying index funds and matching the
market returns while eliminating trading costs and research time
• Louis Lowenstein wrote a paper titled Searching for Rational Investors in a Perfect Storm
where 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 fell
back to 1,100 in October 2002
• This does not reflect underlying business valuations and represents human emotion
at work
• He then looks at 10 value oriented mutual funds that averaged 10.82% annual
returns 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 and
Tweedy Brown American Value
• Lowenstein highlights a August 2000 Fortune article where they selected “10 Stocks
to 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 subsequently
lost 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 which
prohibited them from buying
• During this period value managers were picking up old economy stocks that no one
wanted during the tech boom and patiently waiting for them to rise to more normal
valuations
• “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 at
a price that is significantly lower than your intrinsic value estimate in order to allow for the
inevitable risks of projecting future earnings and cash flow
• “If you understood a business perfectly and the future of the business, you would need very little
in 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 you’d need. If you’re driving a truck across a bridge
that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches
above the crevice it covers, you may feel okay, but if it’s 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 over
institutional investors because they have three major constraints
1. Short-term time horizon
2. Market cap limitations
3. Restrictions on sector/geography/cash levels
• Institutional investors are forced to worry about their performance relative to their peers
over 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 and
holding for the long term rather than buying what other managers are buying so as not to fall
behind their peers in performance
• “An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds
available in equities—at full prices they couldn’t 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 the
fund’s returns
• As a result large institutional investors are limited to investing in companies with large
market 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 can’t purchase retail stocks even if
they are extremely cheap
• A manager with a mandate in Canadian companies can’t purchase U.S. companies even if
they undervalued
• Many institutional investors are also prohibited from holding cash and forced to be fully
invested at all times
• Even if a technology fund manager knows the sector is overvalued he must continue to buy
shares at overvalued levels
• Mr. Market could be giving away dollar bills for dimes, yet these managers would not be
permitted to buy them
• “Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most
professionals 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, rather
he should focus on the underlying business fundamentals
• The value investor should use short term indicators to pick up shares of undervalued
companies
• “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 the
opportunity to keep assets in cash
• “It is painful having money in the bank earning about 2%. Our investment philosophy is
bimodal; 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
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 out
exceptional stocks selling at bargain prices.
3. The 300 largest institutional investors control more than half of the stock
markets’ capitalization. But most underperform the market. This single fact
shows how individuals using the principles of value investing can, indeed,
beat the big mutual funds.