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Kindle Notes & Highlights
by
Sven Carlin
Read between
June 30 - July 2, 2018
Have a liquidity cushion when buying a stock – never buy a full position immediately
A value investor should never buy a full position all at once because even if a bargain stock is trading at $5 while its intrinsic value is $10, it is always possible for the stock to become even cheaper due to various market vagaries. A cash cushion allows us to buy more if a stock trades cheaper and further increase your investment returns.
Partial purchases often give a higher return for less capital employed. This is a perfect strategy that lowers your risk and increases your returns because it allows for increased purchases at lower prices.
Apart from individual stocks, a liquidity cushion must also be applied to the whole portfolio as, especially in market panics, the complete market can go to incredibly low levels! Seth Klarman, the manager of one of the most successful value hedge funds in the world, The Baupost Group and the author of the book Margin of Safety which provided me the inspiration for this book, is known to often have up to 50% of his portfolio in cash when there are no low risk bargains to be found, as was the case in the 2000 dot-com bubble.
Even if the stock market looks extremely scary in a recession due to collapsing earnings and bankruptcies, recessions do not last that long at all. According to the National Bureau of Economic Research, the average duration of a recession in the U.S. from 1945 to 2009 was just 11 months.
The notion of market efficiency is that low risk leads to low returns while only high risk leads to high returns. The first to officially write about this was Nobel Prize winner Harry Markowitz back in 1952 and he is now known as the father of the modern portfolio theory.
Such a statement has led to a proliferation of passive investment schemes where an investor is supposed to just buy a basket of securities at the current price and not to think about anything as the market will take care of his returns. Many institutional investors completely disregard fundamental analysis and buy stocks just based on their market capitalization, the higher the value of a company the more they buy of it.
It is almost funny that Eugene Fama, the Nobel Prize winner and main face behind the efficient market craze has evolved over time and acknowledged that value indeed beats growth investing. The two market anomalies that show how markets aren’t efficient after all, are size and value. Fama explains the overperformance through additional risk but we will see in upcoming parts that a value investor approaches risk in a different way than academia. The findings were published in the now famous 1993 Journal of Financial Economics article by Fama and French; Common risk factors in the returns on
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The extremely valuable data from the research that Fama and French have done is freely available online. I have borrowed the data and the below figure shows the difference in annual returns between the various markets’ value and growth portfolios since 1927 where the portfolios are held for 10 years. The value portfolio is created by putting into it all the traded stocks with the lowest 30% of price to book ratios while the growth portfolio is created with the stocks that have a price-to-book ratio in the highest 30% range of the market as usually high price-to-book values describe growth
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Value investing, on the other hand, is inherently boring, all you need to look at is the price to book value and usually only boring dull companies have low price to book values, there aren’t many exciting growth prospects but there is a margin of safety in the related book value of the underlying assets and stable earnings.
By holding to a well-diversified portfolio where every investment has a margin of safety and is properly uncorrelated, a value investor might underperform for short periods of time but will definitely outperform over long periods of time and especially during a bear market.
The basis of behavioral finance is that people do not behave rationally when it comes to their finances. However, rationality is the basis of the Efficient market hypothesis. Among many behavioral finance topics, the above-mentioned prospect theory and loss aversion are the most famous.
Furthermore, buying a stock at a large discount (margin of safety) to that intrinsic value helps even more. This is why the most important measure of risk for a value investor is the price he is paying in relation to the value he is buying. That’s it. The lower the price is, the lower the risk is. What happened in the stock market in the last month or year has nothing to do with the risk of an investment.
Seth Klarman in his book Margin of Safety, introduces us to a concept that few understand: a declining stock price can increase your long-term returns. Let’s say you buy Company X at a price of $10 and a dividend yield of 5%. If next year the price drops to $5 while the fundamentals stay intact and you reinvest your dividend at that low price, your ultimate returns are much higher than if the stock price would have remained stable.
On the risk side, after 8 years of economic expansion there is a large probability for a recession in the next 5 years. Let’s say that there is a 50% chance of a recession in the next 5 years. Therefore, there is a 50% chance of getting the 5% expected yearly return from stocks and a 50% chance of seeing stocks fall by 50% as it was the case in the last two recessions. This means that for every $100, index investors are risking $50 for a potential return of $27 (5% cumulative return on $100 in five years).
Fundamental risk indicators are the book value, stable cash flow, cash per share and others that limit the downside while the high potential earnings increase the upside.
A perfect example of how stock prices get sometimes detached from reality is the behavior of Pfizer’s (NYSE: PFE) stock price in comparison to its earnings during the 2009 financial crisis. Pfizer is one of the largest pharmaceutical companies in the world and no matter what happens in the economy or stock market people are always going to use their medicines. Perhaps headache drugs will sell even better in a bear market but that is a different story. Therefore, it is not logical that Pfizer’s stock price reacts to economic crises or stock market panics. However, in a stock market panic, most
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The logical thing is that you see the world, gather data and then act on it.
The theory of reflexivity is very interesting and a great way to explain what is going on in current markets. However, you are probably interested in how to make money and in how Soros made money by using this theory. To make money you have to find the climax or reversal point of a self-reinforcing cycle at which the cycle becomes self-reinforcing in the opposite direction.
Therefore, as a value investor you should always try to find companies that do buybacks only when the stock price is trading below book value. This does the opposite of what we just saw, and immediately increases shareholder value.
Warren Buffett didn’t follow the internet craze in the 1990s when most condemned him as old-fashioned, and he is definitely not following the current buyback mania. As Buffett is against buybacks that are above 120% of book value, we have a similar situation to the 1990s where Buffett is considered old-fashioned while corporations indulge in low debt and high stock prices.
However, in the words of Benjamin Graham: Never forget that “Value should scream at you!” Whenever the stock price is below whatever intrinsic value you can come up with by using various tools you know, you have a bargain. When that happens, bet the farm.
I’ll describe here four methods for business valuation as an introduction to the chapter. The four methods are: net present value analysis (NPV), liquidation value, the stock market value and the value to the private owner. The four, in addition to calculating intrinsic value, probably constitute the best way to value a company.
The S&P 500 has a price to book value ratio of 3.1 which means that you can expect less than a third of what you are paying now for the stock if the net assets held were sold at book value. The 3.1 ratio doesn’t even exclude intangible assets.
Therefore, ROIC is an excellent metric to use when comparing investments, all other metrics fade in the long term as a company that manages to compound its capital at a high return rate will definitely do well over time.
However, a stable and high ROIC provides the necessary security that a permanent loss of capital is unlikely.
In his 2000 Letter to Shareholders Warren Buffett discusses how: “Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.” Therefore, the modern value investor has to analyze growth as a key component of value and include growth in the calculation of intrinsic value.
Therefore, the best way to include growth in the calculation of intrinsic value is to be conservative. For example, there is a much bigger possibility that Starbucks grows earnings at 5% per year than 12% over the next 10 years. A lower than expected growth rate provides your intrinsic value with a better margin of safety.
If there is no positive return on investment, value is being destroyed by growth. If there is a big possibility that the business model will create value for shareholders in the future, then one should look at margins. Margins that will likely improve with more scale will lead to value creation and vice versa.
In other words, the CAPE shows when a market is cheap or expensive from a value perspective. When earnings decline in a recession, the standard PE ratio spikes while the CAPE ratio declines alongside lower stock prices as it takes much more time than a recession for average earnings to decline.
There are a number of things an investor can do to take advantage of the CAPE ratio: Rebalance across sectors and countries As time goes by, CAPE ratios vary enormously across different sectors as sector profitability is impacted by its own cyclical patterns. All sectors experience wild swings in sentiment and, consequently, in their CAPE ratios. Long-term value investors can reap huge rewards by carefully rebalancing between cheap and expensive sectors over time. Barclays’ and Robert Shiller’s research has shown that rebalancing an S&P 500 portfolio according to relative sector CAPE ratios
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Look at individual stocks and add the growth factor If you want even better returns than what you can get from rebalancing the S&P 500 and globally, you have to look at individual stocks that are in a temporarily weak sector but are still doing well and perhaps even growing. The growth might not be coming from earnings (as the sector is in trouble), but could come from acquisitions as the best acquisitions are made when assets are cheap. What is also important is to insert economic growth and development into the CAPE. Given that China and India have been growing at staggering rates in the
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The bigger the discount, the better.
Another thing important when investing with a margin of safety is that it shines in a declining market because when corporate earnings start declining, investors look for safety and protection, which can only be found with stocks that offer a margin of safety no matter what happens with the economy in the short term. Stocks that are already depressed might have only little room to fall further in a bear market thanks to their fundamentals.
Consequently, it is essential to constantly compare investments and buy those that offer the largest margin of safety or have catalysts that are going to unlock that value.
The issue with requiring a large margin of safety is that you will often hold a lot of cash. Holding lots of cash is not a bad thing per se, it allows you to invest when the opportunity arises and really achieve high returns with little risk.
An interesting way to approach a margin of safety is to do it in stages. Let’s say you start buying a stock with a small part of your portfolio when the margin of safety is 20%. In case it becomes 40% you buy a larger part, if it goes to 60% you buy an even larger part. In this way, if you invest just 1% of your portfolio when the margin of safety is 20%, you get sufficient time to learn about the company and determine whether the value is real or there are some hidden risks.
The time to buy stocks trading below net cash value is in market downturns when pessimism surrounding the whole market creates high selling pressure and pulls all stock prices down. A combination of 1) sound fundamentals, 2) a business that operates profitably, 3) low debt, and 4) more cash than the market capitalization is the ultimate margin of safety investment.
One of the worst things that can happen to a stock is a dividend cut. Many investors who invest in a company are attracted by the dividend. If the dividend payments are stretched and the dividend is cut during a recession or a temporary sector downturn, many investors prefer to switch for some other holding, even if that might not be the smart thing to do. Additionally, a lower or no dividend yield eliminates the interest from new dividend investors and disables dividend reinvestment plans. The consequence can be terrible for a stock.
What all this means is that if you’re looking for a margin of safety in the dividend a company is paying, the most important safety factor is the sustainability of the dividend. To check whether the dividend is sustainable one must check the available cash and also the operational cash flows, especially how those cash flows change during bad economic times.
To see whether a dividend is sustainable one must look at the company’s current margins and estimate how a recession would affect those margins. Perhaps it is best to look at how the company fared during the last recession or cyclical downturn. If the margins are tight and even a small change in the form of competitor pressure would make the dividend questionable, then there is really no margin of safety there.
An activist investor has the goal of unlocking the value of a company by either changing the management or forcing it to make certain decisions. When a company is in trouble, looking at whether it could become an activist target could provide an additional margin of safety.
Given that it’s impossible to accurately determine the intrinsic value of a stock, the best thing to do is to buy with a large margin of safety in order to allow for human error.
The point is to invest in the sector when the risk is low and the upside is high. The more you know about a sector, the better you will fare.
When a stock price drops and insiders are buying (especially middle management), it’s a clear signal that the employees have faith in the company. However, when there is much more selling than buying, it could be a signal that things in the company aren’t good at all and there is a reason behind the price drop.
The best approach to measuring intrinsic value is by using the three components method: past value, earnings value and return on invested capital.
It is also good to check the dividends paid out in the past or buybacks made to see the capital returned to shareholders.
2) Earnings & expected future returns Here we are going to combine tool #7 Return on invested capital (ROIC), tool #8 Growth as a component of value and tool #9 the cyclically adjusted price to earnings ratio (CAPE), to get to the intrinsic value of Daimler. Intrinsic
Cash per share is a tool to be used when the stock market is collapsing like it was the case in 2002 or 2009. When the market is doing well it will be practically impossible to find companies that trade at a price that is below net cash per share. Nevertheless, checking the cash per share shows how much stability the company offers and the actual creation of cash. As Munger and Buffett would say: “You want to invest in companies that are drowning in cash.”
As recessions will always come because the economic environment is such, make sure to think about how the analyzed company will be perceived by the market in such a scenario. Perhaps you will have the possibility of buying the stock at incredible discounts to intrinsic value. It is incredible how much volatility there is in financial markets when you take a decade long perspective on valuations, stock prices and intrinsic values.
