The Art of Value Investing
How the World's Best Investors Beat the Market
by John Heins & Whitney Tilson
- On Amazon
- ISBN: 978-0470479773
The Art of Value Investing is a collection of wisdom from professional value investors.
My impression of this book is mixed. While it provides a good overview of different styles of value investing, it lacks depth. It jumps from a few paragraphs from investor A to a few paragraphs from investor B, and so on, grouped by topic. Because of that I often found myself thinking: "No, please, don't switch to someone else again, let the current person talk more about the respective topic." Hence I wish the authors limited the number of investors mentioned to just a handful, but giving them more room for their insights and thoughts.
My notes
Introduction
Value investing means different things to different people, but value investors' core belief is that equity markets regularly offer – for a variety of different but predictable reasons – opportunities to buy stakes in companies at significant discounts to conservative estimates of what those businesses are actually worth. If you can consistently get the value of the underlying businesses right, pay deep discounts to those values in buying the companies' stocks, and maintain your conviction and discipline while conventional wisdom regularly goes against you, you can beat the market.
"All Sensible Investing Is Value Investing"
Value investors typically:
- Focus on intrinsic value – what a company is really worth – buying when convinced there is a substantial margin of safety between the company's share price and its intrinsic value and selling when the margin of safety is gone. This means not trying to guess where the herd will send the stock price next.
- Have a clearly defined sense of where they'll prospect for ideas, based on their competence and the perceived opportunity set rather than artificial style-box limitations.
- Pride themselves on conducting in-depth, proprietary, and fundamental research and analysis rather than relying on tips or paying attention to vacuous, minute-to-minute, cable-news-style analysis.
- Spend far more time analyzing and understanding micro factors, such as a company's competitive advantages and its growth prospects, instead of trying to make macro calls on things like interest rates, oil prices, and the economy.
- Understand and profit from the concept that business cycles and company performance often revert to the mean, rather than assuming that the immediate past best informs the indefinite future.
- Act only when able to draw conclusions at variance to conventional wisdom, resulting in buying stocks that are out-of-favour rather than popular.
- Conduct their analysis and invest with a multiyear time horizon rather than focusing on the month or quarter ahead.
- Consider truly great investment ideas to be rare, often resulting in portfolios with fewer, but larger, positions than is the norm.
- Understand that beating the market requires assembling a portfolio that looks quite different from the market, not one that hides behind the safety of closet indexing.
- Focus on avoiding permanent losses rather than minimizing the risk of stock-price volatility.
- Focus on absolute returns, not on relative performance versus a benchmark.
- Consider stock investing to be a marathon, with winners and losers among its practitioners best identified over periods of several years, not months.
- Admit their mistakes and actively seek to learn from them, rather than taking credit only for successes and attributing failures to bad luck.
Price is perhaps the single most important criterion in sound investment decision-making. Every security or asset is a "buy" at one price, a "hold" at a higher price, and a "sell" at some still higher price.
People often make it sound complicated, but investing is really all about estimating what something is worth and then buying it at an attractive price.
Value investors tend to have a different default question in looking at a potential opportunity. Most investment managers ask "Can I own this?" – to which the answer is generally yes. Value investors put a different burden of proof on every idea by asking, "Why should I own this?" That degree of skepticism is a valuable trait.
The market is really just a pendulum that forever swings between unsustainable optimism, which makes stocks too expensive, and unjustified pessimism, which makes them too cheap. All we're trying to do is keep a level head, sell to the optimists, and buy from the pessimists.
Field of Play
Circle of Competence
When successful investors talk about ideas that have gone awry, one key reason often cited has been venturing into an industry, company, or market situation with which they don't have experience or don't yet have a full command. Enough can go wrong even when you're in the center of your circle of competence, why increase the chance of mishap by operating outside of it?
Regardless of how broad or narrow their field of play, the best equity investors are able to articulate clearly where they expect to find investing opportunity and why. This circle-of-competence definition includes the characteristics of companies of interest, with respect to such things as their size, where they operate geographically, their business models, and the industry or industries in which they compete. It also includes the situations that the investor has found can lead to potential share mispricing, such as where a company is in its evolution, where an industry is in its cycle, and when a company or industry is likely to be neglected or misunderstood. All of this informs where the investor will – and won't – look for ideas, and the tactics he uses to generate them.
One of the most basic distinctions investors make in defining their field of play concerns company size. How big a company is can say a lot about its complexity, the sustainability of its business model, how actively followed it is, the volatility of its stock price, and why it might be mispriced.
Central to any accomplished investor's definition of his circle of competence is a description of the industries – or more generally, the types of businesses – on which he focuses. Hard-earned experience would appear to be the most impactful teacher here – the emphasis is usually more on where they will not invest, rather than on where they will.
Deficient Market Hypothesis
An all-too-common error that novice investors make is to assume a consistent connection between the success of a business and the success of an investment in that business. There's no question that successful companies can also be outstanding investments, but that's not necessarily the case. Winning investments arise when the current market price of a company's stock underestimates what you believe its current value is – and you turn out to be right.
Look at almost any company's market value over a multiyear period if you want assess the efficiency of the market. Even the largest, most stable and most liquid company will often exhibit a surprising variability in market price from high to low – a variability that almost certainly goes beyond the underlying change in the company's actual value. This spells opportunity for astute investors.
[...] if an investor doesn't know why something might be mispriced, the chance of it actually being mispriced significantly decreases.
The reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The internet will not make the market efficient, even though it makes far more information available, faster than ever before, right at everyone's fingertips. Markets are inefficient because of human nature – innate, deep-rooted, permanent. People don't consciously choose to invest with emotion – they simply can't help it.
Fear, greed and hope have wiped out more money than any market downturn ever could.
Investment markets follow a pendulum-like swing between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.
The most important change in the business over the past 40 years is probably investors' time horizons. Today the majority of investors – Ben Graham would call them speculators – are focused so closely on this week, this month and this quarter. Did this company meet the estimates or did that one meet its guidance? Stocks are bought and sold on penny deviations from those estimates, which is mind-boggling. Crazy as it is, we can't complain – it just creates more opportunities for investors with longer time horizons.
Fertile Ground
There's a clarity that comes with great ideas: You can explain why something's a great business, how and why it's cheap, why it's cheap for temporary reasons and how, on a normal basis, it should be trading at a much higher level. You're never sitting there on the 40th page of your spreadsheet, as Warren Buffett would say, agonizing over whether you should buy or not. If you find yourself there, it's either not yet clear enough in your head or it's not as striking an idea as it should be.
While value investors are typically considered a risk-averse lot, that's more a reflection of the price they're willing to pay for any given investment than the types of situations they most often pursue, which are often fraught with uncertainty. As companies constantly evolve and change in response to industry or company-specific challenges and opportunities, the lack of clarity around those changes – and the risks inherent in the potential outcomes – can cause share prices to diverge widely from underlying business value. The ability to recognize and capitalize upon that dynamic is a key element of what sets top investors apart.
Change brings uncertainty, so many investors want to wait out that uncertainty until the situation is easier to analyze. We think that uncertainty is what creates opportunities.
Generating Ideas
We consider ourselves first and foremost value investors, but we don't start by looking for cheap stocks. We spend our time following outstanding businesses that we would want to own should they ever become cheap. They're rarely inexpensive when we start trying to understand them, but we follow them closely so that on the rare occasion they become discounted, we can act right away.
Our ideas typically have more to do with the trends in a particular industry than whether XYZ stock looks very cheap. We want to invest in good businesses with industry or company-specific tailwinds behind them, and which happen to be cheap. That's a different mindset from finding something that's cheap and constructing a story about why the negative issues should go away.
I'd much rather steal a good idea than generate a bad one myself.
Building the Case
Cutting Through the Noise
As much as I'd like to be able to control the outcomes, I can't. The only thing I can do is maximize the probability of getting a good outcome by following what I've defined as the right process. A good process doesn't negate bad outcomes or bad judgments, it just tries to mitigate them. It's like a pilot's preflight checklist. Pilots do the same thing thousands and thousands of times in their lives, but they still go through the physical checklist to eliminate what could be a catastrophic error if they try to circumvent it. Investors are well served by having similar types of checklists and sticking with them.
I grew up in the business with the basic assumption that I didn't need to worry much about macro issues as long as I had enough margin of safety from a cheap stock price. That's no longer a safe assumption, so we force ourselves to more fully assess the risks of political, economic, social and technological changes that could derail our thesis.
Only after you understand the business can you understand the stock.
I've always believed that above-average, long-term performance in the stock market is highly correlated with avoiding serious errors, so I always focus on what can go wrong first. I want to know the downside risk potential before looking at the upside. While it isn't in real life, paranoia can be a virtue in the investment business.
We are big fans of fear, and in investing it is clearly better to be scared than sorry.
Rather than start out looking to convince ourselves why we should buy something, we start out trying to prove why we shouldn't buy it.
I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.
Character today is best judged in the proxy statement – what do they pay themselves and how? Is their financial self-interest truly aligned with mine as a shareholder? I have absolutely no problem with the people running huge, complicated, global businesses making a lot of money. The big problem we have now is that you're seeing a lot of superstar compensation for only minor-league performance.
Almost as important as identifying the extent to which a stock is undervalued is assessing what can make that misjudgment by the market go away. After all, the proverbial "50-cent-dollar" that value investors seek will produce a very different investment result if the gap between price and value closes within one year, or if it takes 10 years, For that reason, most – but not all – successful investors put emphasis in their analysis on the potential catalysts that can trigger an enhanced market appreciation for a company's business and its shares.
Investing is about the conclusions you draw from the information you have.
I love the intellectual challenge of investing – there are always new questions to try to answer. But it's important to remember that you don't actually have to answer all the questions you ask yourself. It's like being able to take a test in school where you can answer any 10 questions of your choice on a 100-question test. You answer only those you know well and ignore those that are very difficult to answer. That's what investing is all about.
Always ask yourself what are the arguments on the other side. It's bad to have an opinion you're proud of if you can't state the arguments for the other side better than your opponents. This is a great mental discipline.
I do not hire people I would not want as friends or as neighbors. I work with people who make my life easier. You can't work with people who make your stomach grind.
Getting to Yes
Through creative and diligent research you may uncover fascinating companies in wonderful industries. Through brilliant and incisive analysis you may see unfolding for a company positive events that mere mortals would miss. But all of that is for naught if you pay too much for a stock relative to what you get. Price obviously matters – the cheaper it is relative to what you believe a company is worth, the better.
Consistent with value investors' emphasis on what can go wrong with any given investment, they typically in their valuation work assess a variety of possible upside and downside value scenarios and, implicitly or explicitly, assign probabilities to each before making any final judgments.
In a world in which most investors appear interested in figuring out how to make money every second and chase the idea du jour, there's also something validating about the value-investing message that it's okay to do nothing and wait for opportunities to present themselves or to pay off. That's lonely and contrary a lot of the time, but reminding yourself that that's what it takes is quite helpful.
In a typical year, the average large-cap stock fluctuates about 50 percent from its low to its high. If you've done your homework and you're patient, more than enough opportunities to buy will come along.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Active Management
The Portfolio
There's no question, of course, that intelligent buying decisions are a prerequisite to successful investing. But there's also no question that smart buying isn't at all sufficient to insure success. Equally important are the less-sexy aspects of equity investing involved in portfolio construction and management. How are positions sized? How many positions are held? How actively are holdings traded? How are portfolio risks assessed and what efforts are made to mitigate them? Is hedging a part of the strategy? Is shareholder activism? Finally, among the most vexing topics an investor must address: How do I decide when to sell?
Playing the Hand
We have a rigid rule that if a position is down at least 15 percent from our cost, we force ourselves to either buy more or sell. Human nature in such situations is just to hold, but if our conviction on the idea is intact, we're happy to see it down 15 percent so we can buy more. If that isn't the case, we sell.
Guarding Against Risk
If we can't find undervalued stocks we'll let cash accumulate, as we believe cash is a better alternative than owning an overvalued security. I'd argue that having the patience and discipline to save your cash for when the fat pitches come along is probably the most valuable trait an investor can have.
You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all – not some, all – of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?
Making the Sale
We try not to have many investing rules, but there is one that has served us well: If we decide we were wrong about something, in terms of why we did it, we exit, period. We never invent new reasons to continue with a position when the original reasons are no longer available.
What's important is to try to constantly reassess investments as if you're looking at them for the first time. That's not always easy, but we find it helps keep us from falling into the trap of assuming key assumptions are intact when they really aren't.
Of Sound Mind
Of Sound Mind
What other business is as intellectually stimulating as this? Other than maybe intelligence gathering for national security, I don't know of one. If you like winning, there's a scorecard. If you like game theory and trying to logically deduce what's likely to happen, this is a great application for that and it's very gratifying to be proven correct.
There's a big difference between loving to win and hating to lose, which has a lot to do with one's approach to risk. Someone who loves to win is willing to take a lot of risks because the euphoria of winning outweighs the bad outcomes. If you hate to lose, though, any bad outcome is not acceptable. To be a great investor, I think you really have to hate to lose.
You want to make mistakes once in a while. If you never make a mistake, you're being too conservative and missing profit opportunities you shouldn't.
People forget it all the time, but it's important as investors to differentiate between luck and skill. Over short periods of time, you can do the wrong thing and make a lot of money and do the right thing and look like an idiot. We try to stick to what we do well and not get too caught up in what's working at any given moment. In the long run, that sort of discipline will keep you from blowing up.