01-29-2014, 07:05 PM
Chapter 6: Value Investing: The Importance of a Margin of Safety
In chapter 6, Klarman still does not yet get to the nuts and bolts of value investing, but he does provide a more in-depth conceptual framework. The chapter opens with a concise and clear definition of value investing:
So right off the bat we’ve got a couple of meaty topics for dividend growth investors. First, many DG investors like to buy their shares at as much of a bargain as is possible – this makes perfect sense. But many (including me) also are comfortable buying shares in excellent dividend growth companies at “fair” prices, since these companies are able to grow earnings and dividends over time, and we plan on holding for a very long time. Of course this varies by company. As I’ve mentioned elsewhere, I own both LMT and KO in my portfolio, and I consider them both to be good dividend growth stocks. But I would probably not buy shares in LMT unless it was a true bargain, while I do not demand the same bargain when I buy KO. Second, Klarman clearly contemplates the sale of shares purchased at a discount once they have risen to fair value. Most dividend growth investors seem keen on holding for the income stream, even if share prices rise from the bargain basement to fair value.
Klarman emphasizes the importance of patience and discipline in value investing. He says that a value investor does not worry about being fully invested, and will sit out long periods of overvaluation waiting for the right companies to reach the right prices. “[T]he cheapest security in an overvalued market may still be overvalued,” he writes. Conversely, in periods of market turmoil, there may be opportunities aplenty, and a disciplined value investor will carefully select the very best opportunities.
Klarman devotes several pages to acknowledging that valuing a business is inherently complex, relies on information that cannot be known, and that conditions continually change. He advocates taking a conservative view, assuming the worst to ensure that you’ll never pay more than a great price.
On the importance of the margin of safety, Klarman writes:
Klarman concedes that each investor will differ as to the right margin of safety, and that the answer to that question “comes down to how much you can afford to lose.” More tangibly, he suggests that in valuing a company, a value investor should give preference to tangible assets over intangible. And of course, when you are considering an undervalued stock, it is crucial to understand why it is undervalued.
The chapter includes a long section explaining that value investing is predicated on the efficient market hypothesis being wrong. Buried in this section is the gem: “Technical analysis is indeed a waste of time.”
Finally, Klarman warns that the term “value investing” is often mis-used to describe other, less disciplined investing strategies, and that managers claiming to follow a value approach should be carefully scrutinized to ensure that they do indeed.
In chapter 6, Klarman still does not yet get to the nuts and bolts of value investing, but he does provide a more in-depth conceptual framework. The chapter opens with a concise and clear definition of value investing:
Quote:Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process.
So right off the bat we’ve got a couple of meaty topics for dividend growth investors. First, many DG investors like to buy their shares at as much of a bargain as is possible – this makes perfect sense. But many (including me) also are comfortable buying shares in excellent dividend growth companies at “fair” prices, since these companies are able to grow earnings and dividends over time, and we plan on holding for a very long time. Of course this varies by company. As I’ve mentioned elsewhere, I own both LMT and KO in my portfolio, and I consider them both to be good dividend growth stocks. But I would probably not buy shares in LMT unless it was a true bargain, while I do not demand the same bargain when I buy KO. Second, Klarman clearly contemplates the sale of shares purchased at a discount once they have risen to fair value. Most dividend growth investors seem keen on holding for the income stream, even if share prices rise from the bargain basement to fair value.
Klarman emphasizes the importance of patience and discipline in value investing. He says that a value investor does not worry about being fully invested, and will sit out long periods of overvaluation waiting for the right companies to reach the right prices. “[T]he cheapest security in an overvalued market may still be overvalued,” he writes. Conversely, in periods of market turmoil, there may be opportunities aplenty, and a disciplined value investor will carefully select the very best opportunities.
Klarman devotes several pages to acknowledging that valuing a business is inherently complex, relies on information that cannot be known, and that conditions continually change. He advocates taking a conservative view, assuming the worst to ensure that you’ll never pay more than a great price.
On the importance of the margin of safety, Klarman writes:
Quote:Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.
Klarman concedes that each investor will differ as to the right margin of safety, and that the answer to that question “comes down to how much you can afford to lose.” More tangibly, he suggests that in valuing a company, a value investor should give preference to tangible assets over intangible. And of course, when you are considering an undervalued stock, it is crucial to understand why it is undervalued.
The chapter includes a long section explaining that value investing is predicated on the efficient market hypothesis being wrong. Buried in this section is the gem: “Technical analysis is indeed a waste of time.”
Finally, Klarman warns that the term “value investing” is often mis-used to describe other, less disciplined investing strategies, and that managers claiming to follow a value approach should be carefully scrutinized to ensure that they do indeed.