Some of the most lessons one learns as a value investor is recognizing one can be wrong, and analyzing companies and stocks are at best an inexact science and subsequently one needs to structure the investment approach and process to address and embrace these conditions to properly benefit as an investor. In previous segments part 1, part 2 and part 3 we went through lessons having patience, not losing money, being more buy and hold instead of trading, being contrarian and knowing markets are not always right. In this part 4, the focus will be on knowing our own short-comings and embracing them when investing.
Business Valuation and Analysis is never an Exact Science
One of the most important lessons one learns as a practitioner in the markets is that just when one thinks one has learned and understood a situation, the markets and stocks behave completely differently than expected based on the known data. When it comes to value investing, an investor does deep and fundamental work. One conducts research and analysis various drivers of the business. One critical mistake one can make is assuming one has all the relevant facts about certain investments. For example, there might be variables and questions that are unknown to one as a value investor. All the right questions could not have been asked. This is another way of saying there are “known unknowns but, one does not know the unknown unknowns”. In addition, unlike science, one can know all the facts and data perfectly as an investor and still get the investment incorrectly. Almost all investments are dependent on outcomes that cannot be accurately foreseen. Investment reality is not something stagnant. Business values don’t always stay constant. All of this means that even though one has done the deep analysis, one cannot be certain of a specific value. This results in that as an investor, one cannot ever be confident buying a stock at a discount, as not only are external factors partially driving the value but also that one can never be certain one knows the facts.
Business Valuation Changes
Often one sets an exact value to an investment. As a value investor one have the inclination to set a precise value on something after all the deep work. That is contrary to how the world is built up. One cannot set a precise business value in an imprecise world. All the variables one look at as a value investor, such as book value, earnings, cash-flows are all in end just best guesses. Furthermore, all variables constantly change. Macro, micro and market-related factors give a further level of uncertainty. One needs to continuously re-assess the assumptions and variables one uses to make a valuation. One needs to be cognizant of the difference of trying to make precise assumptions and forecasts with making accurate ones. We can easily have a precise fundamental valuation as we described in our DCF analysis. That does not mean the value is accurate. The output does not mean anything if one does pay full attention to the inputs. “Garbage in, Garbage out” is an easier way of describing it.
In their Value Investing Bible, Security Analysis, Graham and Dodd address this notion a range. They write:
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate – e.g., to protect a bond or to justify a stock purchase or else that the value is considerably higher or considerably lower than the market price. For such purposes, an indefinite and approximate measure of the intrinsic value may be sufficient.”
Sometimes, the simple analysis will give a more accurate assessment of a company’s value than deep in-depth analysis with plenty of uncertainty about the inputs.
How much Margin of Safety is needed?
As we have pointed out several times, as valuation is an imprecise art, the future is unpredictable and we as humans all make mistakes margin of safety is needed when we invest. Especially as value investors. The follow-up question is how much margin of safety do we need to take into account to feel secure in our investments? The answer differs from one investor to the next. It all boils down to how much are you as an investor willing and can afford to lose. This in itself is not a good argument, as no one wants to lose anything, but one needs to take the variable in consideration when assessing how much margin of safety to have in an investment so make sure the likelihood of having losses are smaller.
There are several different ways one can “increase” the margin of safety in the investments one make. This includes when buying something “at a discount”, making sure the majority the value is based on tangible assets over intangibles (for example Goodwill). Not being married to a position/investments and being open to replacing it if an even better offer comes along. Importantly also, selling an investment when the market price reflects the underlying business value. In other words not getting too greedy. These are all indirect ways of building margin of safety on a continuous basis. This means that one does not forget why one made the investment in the first place and selling the stock when that underlying reason no longer applies. Furthermore, this applies to potential investments as well. One should not only pay attention to whether a stock is trading at a discount to fundamental value but more importantly why is it undervalued.
Finally, try to find investments where you can see a clear path to closing the discount. Often for a value investor, the go-to answer is, the stock will stop trading at discount with time as other investors will see the deep discount as well. This might be all fine, but to get to this “value” for one’s margin of safety, look for investments with catalysts that could help either directly or indirectly closing the discount.
All of the above is always easier to accomplish by having a preference in investing in companies with good management that understand the issues and have a big part of their own wealth invested in the business.