In these turbulent times, it’s time to go back to the basics. I picked up my copy of “Security analysis” and started with the foreword by Seth Klarman. Here are a few of the takeaways.
The basic principle of value investing is to buy a business or part of a business for less than it’s worth. You want to pay 40 cents on the dollar. (Or less of course). But how do these opportunities arise? And how do you spot them? These last years stocks haven’t exactly been cheap. Some sectors have, but they are often cyclical. I.e some shipping segments. Somehow we have to figure out the intrinsic value of a company. And when we know this number, we need to add a margin of safety, since everything that might go wrong probably will go wrong. Lets begin with why someone might be willing to sell at a bargain value:
- A sudden need for cash
- A fund manager doing “window dressing” for the next report.
- Margin calls
- Does not know the intrinsic value / inability to perform proper analysis
- A bearish macro view
- Investor disfavor or neglect
That’s just a few reasons. When I participated in the IPO of BE Energy I was willing to pay 24,40 a share. Today it is sold for around 8 NOK a share. Currently the company has no debt, and a cash deposit of around 9,30 NOK a share. In addition the company has producing wells, and oilfield assets that also have value. In theory, you could buy the entire company for less than the cash position, and sell off all the assets. Preferably under better market conditions. So when the price on these securities reaches these kinds of levels, I do not sell. I buy more. That’s why it’s important to always have spare cash. And not let emotions control your behavior.
Of course I can not know for sure that the share price eventually will rebound. It’s not a science, it’s an art. But value investing is about focus on the asset, not current macroeconomic factors.
By definition, value investing rebuffs the “efficient market hypothesis”, and “modern portfolio management”. If the market truly was efficient, there would be no bargains. Ever. MPT insists that with higher returns comes higher risks, while a value investor would argue the opposite. If you have done your homework, know what the security is worth, and also have a margin of safety, you should get higher returns, with fewer securities. Then time is your friend, and the stocks will eventually return to a fair price.
Of course, sometimes you’ll get it wrong. An assumption was wrong. You might not see how technology changes an entire business. In the 90’s the newspaper business might have looked good, with high entry barriers. Then Internet rapidly eroded the business model. Today’s good business might not be tomorrow’s. And sometimes a security is cheap for a reason, aka a value trap. When management doesn’t have the best interest of the investors in mind, underutilization of the assets might occur.
End of part I.