8 Nov 2011 by Jim Fickett.
While all value investors claim “buy below true worth” as a basic principle, Klarman turns this into most of a strategy. For example, he advocates always holding the most undervalued assets, even if this means selling other things “too soon”. And he makes the intriguing proposal that one should not target a rate of return, but rather make the goal simply one of acquiring undervalued assets.
As illustrated in the recent post Margin of safety, the idea of buying well below true worth is fundamental to value investing as implemented by a number of famous practitioners. Klarman, however, takes this principle to a new level. Whereas Grantham discussed waiting until full value was realized before selling, and Buffett buys companies to hold them forever, Klarman suggests always moving on to new assets so as to always hold the most undervalued securities available:
Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.
He admits that buying with the best possible margin of safety is a challenge:
If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot. …
Should investors worry about the possibility that business value may decline? Absolutely. … First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. …
Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.
Nevertheless, he suggests that buying with an optimal margin of safety should be your primary, and in some sense your only, investment goal:
One of the recurrent themes of this book is that the future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.
Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.
Many investors mistakenly establish an investment goal of achieving a specific rate of return. …
Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.
Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.
Klarmsn's success is a strong argument for these views. But each person has to find his own way, and there are two areas where I have a hard time reconciling this strategy with my own view of the world.
First, with Treasury bills currently providing a negative real yield, I do not see them as a good medium-term alternative. I am holding quite a large proportion of cash right now, because I think a major opportunity is coming soon, following a likely crash in Europe. However, at least until I find a process to discover lots of great bargains of the kind that Klarman finds, I will have a significant portion of my portfolio in solid, plodding investments that are likely to (1) have low volatility, (2) provide low but dependable returns, and (3) preserve value in the face of possible high inflation.
Second, although I agree that one must be prepared for any eventuality, and buying cheap is a great way to do that, I also think that understanding trends (and hence attempting to understand at least something about the future) is a good way to add to the margin of safety. No one knows for sure where bond yields will go. But with Treasury yields at all-time lows, and with those lows not pricing in at all the risk of serious inflation, it is very likely that in the medium term bond yields will rise. This subtracts from the margin of safety for most bonds. In the opposite direction, there is a great deal of truth to Jeremy Grantham's “We are running out of everything”, and this adds to the margin of safety in mining stocks and commodities.
Still, the Klarman philosophy fits well, overall, with my own talents and predilections, and I will probably move more in this direction.