Thursday, December 14, 2006

The Art of Deep Value Investing

Charlie Munger said it best when he remarked that, "All intelligent investing is value investing." Quite simply, value investing can be defined by two fundamental metrics:

1. Look for a business trading below its intrinsic value.

2. Invest with a margin of safety.

In other words, pay attention to price. A fantastic business is not a fantastic investment if the price is wrong. In my obsessive pursuit of understanding the true mechanics of Grahamian value investing, I went looking for some insights into the complex art of deep value investing. I found some wonderful words of wisdom from Seth Klarman, value investor extraordinaire and founder of The Baupost Group, a value driven hedge fund. Mr. Klarman has been compounding money at over a 23% clip for the past two decades. At a recent talk at the Columbia Business School, Mr. Klarman shared his thoughts....

If only one word is to be used to describe what Baupost does, that word should be: ‘Mispricing’. We look for mispricing due to over-reaction,”

Markets are never completely efficient. There will be times when Mr. Market goes crazy and offers to sell dollar bills for fifty cents. Taking advantage of these opportunities can generate enormous returns. But to do so, you have to constantly be working and working and working...why should it be easy to get rich?

“Investors can not predict when business values will rise or fall. Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods.”

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world,”

Consider the Washington Post Company in the early1970's. At one point, the market cap of the Post was around $80 million yet the media and publishing assets of the company could have easily fetched $400 million in a fire sale liquidation. Eighty cents for four dollars sounds like a pretty good margin of safety. Valuation is not an exact adequate margin of safety, usually 50%, helps cushion against "volatility" and "bad luck."

Look at investments as "fractional ownerships."

How else should you look at buying shares in a business?

Ultimately, investments generate profits in three ways:

1. From the free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.

2. From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

3. Or by closing the gap between share price and underlying business value.

So how do you find profitable investments?

"Value investing requires a great deal of hard work, unusually strict discipline and a long-term investment horizon"

Seth Klarman wrote a book, Margin of Safety, that is a blueprint for a sound investment approach. Unfortunately, the book is out of print and last time I checked, a copy was fetching over $1300 on eBay. However, most university libraries ought to have a copy or should be able to be able to point you in the right direction.

1 comment:

Anonymous said...

Excellent post!