MODERN VALUE INVESTING: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment

by Sven Carlin

The sustainability of the dividend depends mostly on whether there will be a recession. However, as a new recession will always come, those who look to invest in cyclicals might really want to do so when the stock price falls significantly below the intrinsic value during a bear market and a recession. Daimler’s stock fell more than 70% in the last two recessions with bear markets so we can expect something similar in the future.

Table 23 - Summary of applied tools Source: Author’s data

There are several ways to deal with portfolio liquidity. Constantly adding new funds to one’s portfolio certainly helps as it enables an investor to hold onto certain illiquid investments that still have to appreciate, and allows to not miss new investment opportunities, thus lowering the opportunity costs. Additionally, long term investors can certainly hold on to illiquid investments without too much stress, but they definitely have to demand a high reward for the illiquidity.

As we never know what will happen on the stock market it is wise to never buy a full position in a stock all at once. Buying a whole position in one buy might force you to helplessly watch the stock further decline while you don’t have any more buying power. Buying in small stakes allows the investor to average down in declining markets. As the stock recovers you can sell the positions you acquired over time at a higher level in order to manage your portfolio risk and book a small profit. Over the long term those small trading profits around the margin of safety compound to amazing investing returns.

The decision to sell is also influenced by what else is on the market at that specific point in time. If you find a great bargain, it would be wise to sell a stock that hasn’t yet fully realized its value in order to exchange it for a better bargain.

Apart from fundamentals, there could be other reasons to sell a stock. For example, there are some catalysts that should positively influence a stock in the next few months, like the launch of a new product. If the product isn’t what you or the market expected, it’s ok to take a loss and sell because the circumstances have changed and consequently the intrinsic value is lower.

Another reason to rebalance is because you have too much risk in one stock. If you usually hold 10 stocks in your portfolio and balance the risks, then each stock should have a weight between 5% and 15%. If a stock that makes 10% of your portfolio doubles, then it would make 18% of your portfolio creating a larger exposure. Given the high proportion of risk in this one stock, it might be wise to trim the position since anything can happen, especially if such a large part of a portfolio is in one stock that has perhaps seen its stock price go up but has seen its fundamentals unchanged.

Stock prices go up and down all the time and to be constantly trading your portfolio around just because this or that stock might look a bit better would lead to high transaction costs that would eat up all your returns. However, I’ve found the best strategy related to this issue with the famous John Templeton. He would replace one holding in his portfolio only when another holding was 50% better than the first one.

For example, if you own an S&P 500 portfolio, buying a put option on the S&P 500 gives you security in the event that the market crashes as you won’t lose anything because the value of the put option should appreciate at the same rate the S&P 500 declines.

but diversification means owning uncorrelated assets.

The best hedges against quantitative easing are assets that are fixed in supply like precious metals, fixed supply real estate like land, and commodities that have a fixed supply but stable demand.

It’s often overlooked, but the U.S. dollar has lost 40% of its value in comparison to a basket of major global currencies in the last 30 years. As currencies usually move in cycles of a few years, the best strategy is to have a well-diversified international portfolio and then rebalance the weights according to the strength of the currency and the margin of safety within the investments.

So, a rational investor might use options in order to hedge a position that perhaps appreciated significantly in the past and is now overvalued. However, an option protects from the downside and can be a great insurance if it is cheap. The lower the market volatility is and the higher investors’ complacency is, the cheaper the options are. Selling put or covered call options when balancing one’s portfolio is also a useful strategy in certain circumstances but that goes beyond the scope of this book.

What often leads to wrong investing decisions is anchoring to previous price levels. It's extremely difficult to avoid anchoring your value calculations to a previous stock market price because it is in our nature to do so. Also, investors tend to think their insight is special and that their insight gives them an advantage over their peers. This could be the case only if the analyst has more research on the matter than anybody else in the field. If not, beware of such overconfidence.

The final rule is an essential for any kind of investment. Look for value and a margin of safety. When the value for shareholders is significantly higher than the current stock price—even in the case of the worst possible scenario including a recession, CEO, CFO resigning, accounting scandal, or dividend cut - bet the farm!

The usual all-weather portfolio described in the media is 30% stocks, 40% long-term bonds, 15% intermediate bonds, 7.5% gold, and 7.5% commodities. However, such a strategy is wrong from the start because an all-weather portfolio is not about precise portfolio allocations but is all about risk. Thus, to create one you have to look at what is the risk of a certain asset class in relation to the economic environment and price. Here is where value investing comes in handy. Once you have done that, proceed with the creation of such a portfolio and consequently rebalance according to the changes in risk as soon as a part of the portfolio carries too much or too little risk. A value investing approach to risk, where risk is perceived as the potential for a capital loss and not as previous volatility really helps in proper rebalancing and portfolio allocation. In the following four economic scenarios I try to build an all-weather portfolio for the current environment while using just a few asset classes to better describe the concept.

To be exposed to a growing economy with inflation above expectations, which is a scenario not to disregard as emerging markets’ demand might spur global inflation, the best thing to do is to own emerging market bonds or dividend stocks alongside commodities. I prefer commodity stocks because they offer you a yield and their earnings increase disproportionately when commodity prices increase.

For example, when stocks in general trade at a CAPE ratio below 10, history has shown that average 10-year returns are around 10% and negative returns are out of the question. Thus, at such a point, stocks offer extremely low risk and should make up a large part of your portfolio alongside high yielding treasuries. In such an environment, gold prices would probably be sky high so you would sell that part of your portfolio risk to buy stocks.

Temporal diversification enables you to be well diversified through your investing lifetime but without overpaying for diversification. For a simple example, let’s look at the Nasdaq index. The Nasdaq is the place to go for tech diversification, but the index is much more volatile than the S&P 500 and it gets crushed in recessions only to quickly turn into a bubble in periods of economic growth. Figure 40 The NASDAQ index Source: Author’s data Therefore, the logic behind temporal diversification would suggest diversifying your portfolio with tech only in periods of economic downturns. This seems a very strange concept and difficult to grasp especially in an environment where news is constant and economic cycles are easily forgotten, but the average economic cycle since 1945 in the U.S. has been 68.5 months from peak to peak. This means that in our average 40 year investment life span, we will have the opportunity to invest in 7 recessions.

The things extreme investments have in common are limited supply and expected stability. On the limited supply side, you can’t significantly increase the number of New York penthouses nor the number of cozy Central London Victorian houses. So, we have to look for investments where the demand will outpace supply while the supply is relatively fixed. Given the global expansive monetary policies, we can continue to expect a constant increase in the supply of money which makes price explosions like the ones we described at the beginning of this article even more likely to happen in the future. On the expected stability end, no one expects a drop of 50% or more in the S&P 500 at this point, so buying out-of-the-money put options is an extreme investment that could lead to a nice payoff.

By allocating 5% of your portfolio to gold investments, you protect yourself from future potential financial turmoil coming from the unprecedented monetary easing policies and low interest rates combined with slow economic growth. If you can stomach volatility, I would definitely go for gold miners. But if you prefer more stability, then actual gold would also do the trick of protecting your portfolio where you limit your downside but the upside is also trimmed. In order to allow for liquidity and make rebalancing easy, a Gold ETF doesn’t seem like such a bad idea.