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The right balance between trend watching and bargain hunting [ClearOnMoney]
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The right balance between trend watching and bargain hunting

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Commentary

The right balance between trend watching and bargain hunting

14 Nov 2011 by Jim Fickett.

Seth Klarman paints the choice between trend-driven investing and value investing in stark terms that are a little hard to interpret pragmatically. After discussing some specific examples, I conclude that trend-watching is consistent with Klarman-style value investing provided (1) the trend-watching is driven by specific value-related questions, and (2) adequate time is left for valuation of specific securities.

Seth Klarman, in Margin of Safety, is not a fan of trying to figure out where markets are going. In directly contrasting value investors with those who try to understand and bet on trends, he writes,

value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities. …

a great many professional investors employ a top-down approach. This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them. This approach is difficult and risky, being vulnerable to error at every step. Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy on particular industries, and finally on specific companies. As if that were not complicated enough, it is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers. …

There is no margin of safety in top-down investing. Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. …

By contrast, value investing employs a bottom-up strategy by which 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. …

The primary goal of value investors is to avoid losing money. Three elements of a value-investment strategy make achievement of that goal possible. A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money. An absolute-performance orientation is consistent with loss avoidance; a relative-performance orientation is not. Finally, paying careful attention to risk—the probability and amount of loss due to permanent value impairments—will help investors avoid losing money.

This is rather black-and-white. I would differentiate betting on trends, i.e. trying to discern and profit from the direction of a market, from trend-informed value investing, where one is driven mainly by value, but one's understanding of value is informed by the broader context.

It is true that betting on trends, which is all about the direction of a market, is fundamentally incompatible with value investing. But trend watching can be compatible with value investing when it adds information to the value equation.

Note, though, that even with trend-informed value investing, there is some tension over priorities, in that watching the news and following trends can take a great deal of time, making it difficult to also find the time for fundamental analysis of securities.

To make these issues concrete, I'd like to discuss what I think the consequences of Klarman's ideas might be in three specific areas of my own investing.

Natural gas

The core of my interest in natural gas is that it is very clearly underpriced – it is selling for less than it costs to produce. That is in line with value investing.

However I have spent a great deal of time tracking the trend, and relatively little time trying to estimate cash flows and likely values of securities. I suspect Klarman would say something like, “The basic idea is a good one. Now you should do your homework and figure out what those stocks you bought are really worth.”

I have had decent success finding areas where there was clear value, and investing without trying to quantify what I hoped to gain. And in fact I've always been a bit skeptical that one could quantify the extent of underpricing. However Klarman's success has inspired me to put more effort in that direction. We'll see how it goes.

Gold

I have said many times that (1) with the current debt crisis, I would not be surprised at all to see gold go higher, but (2) I see no margin of safety in gold.

I bought gold long ago, mostly when it was selling for less than a fourth of the current price. Some months back I realized that my gold holdings had grown to be about 10% of the portfolio, and that was more than I wanted to risk on something with no margin of safety. So I gradually sold the position down, and now hold 5% of the portfolio in gold.

Since Klarman states that assets can be valued only on the basis of cash flow, it would seem he would never be interested in gold. Ignoring assets with no cash flow is too extreme for me – if someone were to offer me a Rembrandt original for a dollar, I would not hesitate.

However with the price of gold well above its long-term inflation-adjusted average, and with no objective way to value it, I would agree that a gold position, currently, is not a value-investing position. So here I am forced to admit that I am, in fact, betting on a trend rather than making a value investment. In fact, I think it is so clear that multiple fiat currencies will be devalued in the next few years that gold is a relatively good bet. It is risky, and yet I think the trend is a very likely one. I would be more comfortable with true value investments, though, and if I find enough good ones I will let the gold go.

Europe

In watching the debt crisis in Europe, my main goal is to have some idea of the likelihood and timing of a major financial shock, which would affect business conditions strongly, first in Europe, but probably worldwide. When it comes to my own investing, there are two main practical consequences.

First, I'm just plain not interested in financials right now. This is perhaps a little extreme, but still in line with value investing. Why waste time analyzing bank stocks when you have no idea what their CDS exposure is to an Italian default? There is no way to estimate cash flows realistically.

Second, I'm inclined to set the bar very high on buying mining or consumer stocks, because it seems very likely a real bear market is coming that will present better opportunities.

I suspect Klarman would disagree with this second aspect of my Europe-watching, saying that instead of trying to guess when the best opportunities will occur, it is better to spend time looking for opportunities, and taking what comes.

I could defend my approach by pointing out that I've done fairly well selling when the market as a whole is overpriced, and buying when it is cheap. However I have to admit that to do this, one does not really need to watch the politicians hour by hour and try to predict where the market is going. It is enough to keep an eye on the overall value of the stock market, and to have some idea of where the main risks lie. In sum, reading Klarman makes me realize that watching the details of the crisis unfolding in Europe, while fascinating, contributes relatively little to my investing.

Conclusion

The key lessons from Klarman are,

  • Bet on value, not direction. One should indeed be very cautious about betting on the direction of a market rather than on fundamental value because, although it is always useful to try to understand the broader context, one should be quite humble about trying to predict the future
  • Watching trends can be a great way to discover and help evaluate value opportunities; however (1) there should be a clear investing goal in the trend work, not just an interest in following the news, and (2) following the trend should not crowd out the activity of valuing individual securities