Chapter 7: At the Root of a Value-Investment Philosophy
In Chapter 7, Seth Klarman describes the three central elements to a value-investment philosophy. This is generally more high-level stuff, and I am starting to wonder if he is ever going to get around to actually explaining how to identify value situations that present a margin of safely.
First, he says, value investing is a “bottom-up” strategy. Many “investors” use a “top-down” strategy that involves predicting macro-economic trends, determining the investment implications of those predictions, and then deciding which sectors or companies are likely to benefit from those implications. As Klarman frames it, this is an incredibly complicated undertaking with numerous opportunities to be wildly wrong. When you take a bottom-up approach, however,
This is a far simpler approach, more amendable to success, that can essentially be described as “buy a bargain and wait.”
Second, value investors must adopt an absolute-performance orientation. The goal must not be to outperform the market generally or other investors. Value investors, Klarman states, are interested in returns only insofar as they relate to the achievement of their own investment goals. While there is some appeal in this position, and I have certainly heard it espoused by many dividend growth investors, I’ve never understood why anyone would want to blind themselves to how their strategy performs relative to, say, broad market index funds. If I knew that my strategy, after a long-enough time period, was underperforming the indexes, I like to think I’d be smart enough to admit that either my strategy or execution was flawed and save a bunch of time and money by switching to index funds. My goal is not specifically to “beat” the index, but if I learned I was consistently trailing it, that would be a strong signal that changes are needed.
Third, value investing is a risk-averse approach in which as much attention is paid to risk (what can go wrong) as to return (what can go right). Klarman cautions that risk and return are not always positively correlated, and that risk is not synonymous with volatility (there is a whole section warning against putting much faith in beta as a measure of a security’s risk).
There is a short and interesting section on the nature of risk, in which Klarman explains that risk – defined as the probability and magnitude of an adverse outcome – “is a perception in each investor’s mind” that (unlike return) “is no more quantifiable at the end of an investment than it was at its beginning.” Klarman concludes that there are only a few things that an investor can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety.
In Chapter 7, Seth Klarman describes the three central elements to a value-investment philosophy. This is generally more high-level stuff, and I am starting to wonder if he is ever going to get around to actually explaining how to identify value situations that present a margin of safely.
First, he says, value investing is a “bottom-up” strategy. Many “investors” use a “top-down” strategy that involves predicting macro-economic trends, determining the investment implications of those predictions, and then deciding which sectors or companies are likely to benefit from those implications. As Klarman frames it, this is an incredibly complicated undertaking with numerous opportunities to be wildly wrong. When you take a bottom-up approach, however,
Quote:individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor’s top-down views are considered only insofar as they affect the valuation of securities.
This is a far simpler approach, more amendable to success, that can essentially be described as “buy a bargain and wait.”
Second, value investors must adopt an absolute-performance orientation. The goal must not be to outperform the market generally or other investors. Value investors, Klarman states, are interested in returns only insofar as they relate to the achievement of their own investment goals. While there is some appeal in this position, and I have certainly heard it espoused by many dividend growth investors, I’ve never understood why anyone would want to blind themselves to how their strategy performs relative to, say, broad market index funds. If I knew that my strategy, after a long-enough time period, was underperforming the indexes, I like to think I’d be smart enough to admit that either my strategy or execution was flawed and save a bunch of time and money by switching to index funds. My goal is not specifically to “beat” the index, but if I learned I was consistently trailing it, that would be a strong signal that changes are needed.
Third, value investing is a risk-averse approach in which as much attention is paid to risk (what can go wrong) as to return (what can go right). Klarman cautions that risk and return are not always positively correlated, and that risk is not synonymous with volatility (there is a whole section warning against putting much faith in beta as a measure of a security’s risk).
Quote:In point of fact, greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.
There is a short and interesting section on the nature of risk, in which Klarman explains that risk – defined as the probability and magnitude of an adverse outcome – “is a perception in each investor’s mind” that (unlike return) “is no more quantifiable at the end of an investment than it was at its beginning.” Klarman concludes that there are only a few things that an investor can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety.