The following is an extract of an interview which I prepared for. Hence, the divider might not seem to make sense. Bear with me.
The following is an extract of an interview which I prepared for. Hence, the divider might not seem to make sense. Bear with me.
What is “value investing” in your own words?
Loosely speaking, there are two general fields of value investing. The contemporary side is to look at growing business at a reasonable price. These can be business of any size, as long as they demonstrate real growth. Mathematically, real growth is not just an increase in revenue but also an increase in cashflows. A true synergy should result not just in bottom line improvements, but also profit margins.
So this is what Graham call investing by projection. The pro of this approach is that time is usually a friend. As the business compounds its value over time, even if you have been a little off with your valuation. This is the more well known version of value investing today.
But I think this approach is harder because you have to think about moat, disruption, etc. You also have to assume certain numbers about the growth and discount rates. If you ask a fellow investor of the same company, what the price is worth, it can differ a great deal. You can easily overpay for quality. Just look at Alibaba at the moment.
So you usually hold on to these companies as the value compounds. If you pick the right company, sometimes you don’t ever sell them. That is the best thing about GARP-- you buy one decent company and time compound its value wonderfully. Not 100-baggers were a result of a year or two of brilliance.
The other side of the fence is investing by protection. So you look at the business from liquidation value. You look at its assets, you look at its liabilities. Usually the business quality is average because the market is not that stupid. So there might be problems with the company, but there should not be an issue with it as a going concern*. Investing in cheap companies is where I am comfortable in.
GARP is usually a qualitative bet while investing in cheap companies (“by protection”)is usually a quantitative exercise. It is far easier to tell that a company is cheap than if it is good.
With buying cheap companies, you are more likely to sell when the value-price mismatch has narrowed. I prefer to invest by protection. When the price goes down meaningfully, 15% or more, I feel extremely comfortable to invest even more money… The odds are better when the price is going down. I am not an institutional investor so I can wait for a long time for value to revert. I don’t have anyone to answer to. So I could buy the more reprehensible company imaginable. But there is a lot more churn (buying and selling) than GARP.
I think value investing has been unfairly bashed and, the process, over simplified.
Value investing is more nuanced than just looking at price to books and PE ratios.
I pay attention to news about companies or sectors with problems because I have a healthy respect for EMH (efficient market hypothesis)—again I think discounts only comes with uncertainty and problems. But the management should not be the source of the problem.
When a company becomes that cheap, as Walter Schloss says, many good things can happen. He called it 3 strings to a bow: first… the company could buy back shares; secondly, if the company is that cheap, it can be bought over; and lastly, the problems could be resolved over time and value can revert.
So the perfect opportunity is when a GARP becomes cheap statistically and it is under a problem through no fault of its own (stock market crash, sector issue). I tend to look at company valuation by enterprise value (market cap + debt minus cash) divided by average earnings, not EBIT or worse EBITDA. I am very conservative.
The typical value investor portfolio usually consist of a mix of these along with special situations as a form of protection. Special situations include arbitrages, spin-offs, and restructuring. These special situation stocks depend far more on corporate action and less on market sentiments… they can be a drag during bull markets but are wonderful buoys during bears. On a long-term basis, participating in only special situation stocks would be satisfactory.
I have a healthy respect for the efficient market hypothesis. Most stocks are fairly priced, or should I say overpriced given how conservative I am, most of the time. The only time where price falls far from value is when there is uncertainty.
The scope of this uncertainty/problem could range from globally or regionally, or an entire sector, or just the company alone. I find that in the same order, the frequency of this kind of opportunity goes from high to low, and the potential returns are from fair to high.
Scope of Uncertainty | Frequency/Incidence | Potential Returns |
Global/Regional | Low | Fair |
Sector | Medium | Medium |
Company | High | High |
Always look at what the insiders are doing.
I think the key to doing fine in investing is to understand the limits of your ability. The stock market is like stepping into an exam hall that provides you thousands of exam questions, and those with the highest marks are not necessary the ones with the hardest question.
I am a simpleton, so I spend time looking for easy problems. I find my patience tested constantly, both by waiting for the simple problem, and also by the value reversion. Quite often I find myself losing discipline. So I understood what Buffett meant in the introduction of the revised edition of "The Intelligent Investor"
"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline."
What most value investors would neglect to tell you, is the emotional worry between buying and that very moment where the seed sprouts (if it happens). The state of the mind frequently swings between stubbornness and self doubt.
That, is value investing in my own words.
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