A Look at Value Investing

I have no doubt  that value investing is based on inherently sound principles and it could be a source of consistent profits over time. I am not sure if it is a style suitable for everyone. It requires an amazing patience, an iron will to overcome naturally ingrained biases and a strong stomach to get over temporary setbacks. This is the good news for those willing to devote to this investment style. If everyone was practicing it, it would not be so profitable.

On the surface value investing looks like shopping. If an $80 shirt is suddenly on sale for $40, you got yourself a deal. Capital markets are actually quite different than consumer markets. There is a big difference between shopping for a shirt and buying a financial asset. If you are an end consumer, you buy a shirt in order to wear it. You have no intention to make money out of it by re-selling it or renting it out. You purchase a financial asset with a plan to profit from it by playing one of two roles:

– a retailer, who buys with the intention to sell for a gain later or

– an investor, who buys for the income in terms of capital gain and dividends.

In capital markets price volatility is much higher than fundamentals’ volatility. Stocks that drop from $80 to $40 look like a bargain, but they may continue to look cheap all the way to $20. The fact that an asset seems attractively priced doesn’t mean that it can’t go even lower. In theory such huge discrepancy between value and price should not exist as arbitrageurs should offset the extremes. In practice such an event occurs much more often than most investors are willing to admit. The job of a value investor is to figure out: why is the price down and why the market is not seeing the existing value? Is the reason behind the sell off fundamental or emotional?

Value investors base their market approach on the assumption that the economy and  investors’ confidence are cyclical. They realize that in short-term perspective prices are heavily impacted by risk appetite, not by net asset value, cash flows or growth prospects. Occasionally emotions and biases become the main driving force of  investors’ decision making. Experienced value investors know that recessions happen often enough to offer great buying opportunities and economic recoveries always follow. When they do, risk appetite comes back and prices rise.

Essentially value investors make a  bet on the human nature – after all it hasn’t changed since the beginning of time. Market often acts irrationally as people forget all logic and become slave to their emotions. When people are in capital preservation mode, suddenly the return OF capital becomes more important than the return ON capital and investors rush for the exits at all cost. At this point there is not enough liquidity to meet the supply and prices might fall quickly. A patient value investor, who is also a good risk manager will come and will start to nimble, gradually building a position that he will sell later at much higher prices, probably to the same people who sold to him when they were scared.

I distinguish three basic approaches to value investing:

– very conservative: they don’t care about future cash flows and discount rates, because they realize that they cannot be forecasted with good enough precision. There is one important question to be asked -If I pay the current market price,  am I going to make money in case this business liquidates tomorrow? They calculate the market value of all liquid assets; give a good 50-70% discount to the current book value of the inventory and fixed assets, assume that intangible assets’ value is zero, subtract from all that the debt and if the remaining sum is still higher than the current market cap, they’ve found an investment candidate deserving further investigation. If this company survives, its fixed assets are likely to costs much more than they were accounted for. Such positive development would be considered a bonus. Now you may wonder, why would a company sells below its net liquid assets value? There are times when emotions reign supreme, when the return of capital becomes more important than the return on capital and investors want out at any price. Such times create opportunities for patient investors with deep pockets.

– pay fair price for good businesses: recessions occur frequently enough to offer favorable entries in good businesses and the stock market eventually always come back due to the cyclical nature of the economy and investors’ risk appetite. The important question here is – is the company going to survive the economic turmoil. If yes, when the economy starts to recover, the market will recognize the value and prices come back to pre-recession levels or higher.

– using reversed engineered DCF model. By taking into account the current price, a conservative (high) discount rate and current year’s operating cash flow, the projected growth is calculated. The main question here is – is the already embedded in the price growth sustainable based on historical reference? This approach provides a general estimate of that how overvalued or undervalued is a stock. It doesn’t provide a buy or a sell signal. Market can remain irrational for a long, long time.

The goal of value investors is not to beat the market benchmark every quarter or every year. There will be periods when they will underperform for 2-3 consecutive years, followed by times when they will be up 500-600%, which will more than offset any previous disappointments. To use a baseball analogy, they are looking for home runs, not doubles and triples.

Of course, value investors also make mistakes. As Warren Buffet likes to point out – “if I ever write a book about investing mistakes, it will be autobiographical”. The most often met mistakes in value investing are associated with the timing of an entry. Sometimes you have done your analysis, all the existing evidence points out that it is right, but the market may not agree with your thesis for years. In the meantime your capital is locked in a position that doesn’t produce cash flow and if you manage other people’s money – they might start to question your analysis. If you enter too early, you might experience significant losses. Are you able to tolerate them? If you manage other people’s money – are they able to tolerate them? Someone said that if you want to make 100% return you have to be willing to experience a drawdown of 20%. You can’t go down 20% with other people’s money. If you are too leveraged and start to get redemptions from scared customers, you will become a forced seller.

There is a saying that the difference between a great value investor and a good value investor is that the former knows how to time its entry properly. Timing is hard. Trying to build big position by timing the market is harder, because catching the absolute lowest point is a matter of luck. Even if by some accident you happen to catch it, the liquidity at the bottom is usually way too shallow. Correct timing  is not about catching the absolute bottom, it is about getting into a neglected stock that won’t remain neglected for too long.

Experienced value investors minimize the negative impact of timing by keeping plenty of cash and by gradually building new positions. Most of their investments could be essentially described as well in-the-money calls without an expiration date.

– ITM because there is margin of safety in the position (even if the underlying company is liquidated, what is left after debt payments will be higher than the market cap at which it was purchased);

– call options, because the potential reward could be tremendous (5-10 times the paid price  or even more);

– without expiration, because they keep plenty of cash reserves and aren’t leveraged; therefore they can’t become forced sellers before their thesis materializes.

The true value investor is a very rare bird that represents a very small part of the investors’ community; probably less than 1% of all involved in the stock markets. I have a huge respect for the people who have the mind to practice this contrarian investing approach. Their abnormal long-term profits are fully deserved. From psychological stand point everything is against them. It takes a special kind of character to overcome all biases wired in the human brain – our desire for instant gratification, our inability to feel financial pain for longer periods of time, our urge to jump from one market method to another when things are not going flawlessly. At this point of my life, I realize that I am still not patient enough, not able to stomach big drawdown in my portfolio, unwilling to go against the trend in order to be a good value investor. Maybe this will change with time.

P.S: over the weekend I will take a look at the underlying dynamics of momentum investing. I will present my view on why it works, how it works and when it works.