Here’s a great article at the The Outstanding Investor Digest that includes comments and answers from Seth Klarman at a symposium entitled “Celebrating 75 Years of Security Analysis”. During the symposium Klarman provided a number of valuable investing insights and honored the legacy of Graham and Dodd saying, “Graham and Dodd teach us not only about investing, but also thinking about investing”.
Here’s an excerpt from that article:
Sometimes, being too early is the same as being wrong….
Seth Klarman: For years, when someone asked me what my biggest fear was as an investor in managing my portfolio, my answer was that it was buying too soon on the way down from often very overvalued levels. I knew a market collapse was possible. And sometimes, I imagined that I was back in 1930 after the market had peaked the year before, and then dropped 30%. Surely, there would’ve been some tempting bargains then. And just as surely, you’d have been crushed by the market’s subsequent plunge over the next three years — down to below 20% of 1929 levels.
A fall from 70 to 20, and from 100 to 20, would feel almost exactly the same by the time you hit 20. Sometimes being too early becomes indistinguishable from being wrong.
After a 30% drop, who knows how much further it might go?
Klarman: Of course, getting in too soon as the market falls involves great risk for all investors, including value investors. Certainly, when a few securities start to get cheap even as the bull market continues, a value-starved investor will step up and buy them. Soon enough, many of these prove to be no bargain at all, as the flaws that caused them to be rejected by the bulls become more glaringly apparent when the world gets worse. After a stock market has dropped 30%, there’s no way to tell how much further it might have to go. It’d be silly to expect every bear market to turn into the Great Depression.
But it would be equally wrong to expect that a fall from overvalued to more fairly valued couldn’t badly overshoot on the downside.
We’re bombarded by apparent opportunity….
Klarman: So when individual stocks reach levels where they are truly undervalued, what are value investors supposed to do other than to buy them? Anything else is market timing. Investors live in real time — not in several year intervals, but in months, days, hours and even minutes. Because we cannot know the future — and cannot see in the middle of the cycle its end, and not even necessarily its beginning — we will be bombarded by apparent opportunity as the market descends. We will see tempting bargains and value imposters, false rallies and legitimate recoveries, smart bottom fishers and mindless buy-the-dippers — and we will never know until after the fact how low things might go.
We can become macro forecasters, predicting 10 of the next two recessions, or we can ignore the macro economy, buying bargains that cease to look cheap as the economy deteriorates and credit contracts and the tide goes out on all marketable securities.
In a market like this, most investors lose their rudders….
Klarman: When a value investor is tempted to become something other than what he or she is, I find it best to recall the wisdom of Graham and Dodd. Graham and Dodd have provided us with a remarkable road map that has been carried on some of the world’s most successful investment journeys for 75 years — a road map that allows us to navigate through difficult, even uncharted, territory and come out ahead.
In a market like we’ve been experiencing, most investors lose their rudders. They become incapacitated, unable to navigate amidst extreme turmoil, declining corporate results, and a litany of economic woes and mounting losses.
They become unwilling to part with their cash — afraid of possible redemptions, and afraid of adding to their losses. Investors today, who are tempted to pull out of the market and wait for some kind of “all clear” signal before recommitting, would be well advised to remember the counsel of Graham and Dodd who wrote in 1934: “While we were writing, we had to combat a widespread conviction that financial debacle was to be the permanent order.” If they could say that then, I must restate it now.
Value investors have a multifaceted and adaptable tool kit.
Klarman: Value investors who are able to maintain their focus and resist the pressures inherent in the investment business to pursue short-term results have a multifaceted and adaptable tool kit that should allow them to prosper even in difficult times. First, by maintaining their discipline and by remaining patient in good times and bad, value investors own bargains — securities trading at a discount to underlying value which confer a margin of safety. This doesn’t mean those holdings can’t or won’t drop in price; it means that when they decline, they’ll be an even better bargain to which you are likely to seek to add.
In difficult times, value investors certainly benefit from their relentlessly-kept discipline by having avoided highly leveraged stocks, troubled financials, perpetually marginal businesses, and risky junk bonds. When the market drops, holders of such speculations quickly regret their choices.
Warren Buffett’s advice is wiser than ever today….
Klarman: Most value investors paint from a broad palette — taking advantage of the best bargains across a variety of industries, countries, and for some, even securities types. They don’t fall in love with companies or their managements. They favor what is undervalued and shun what is overvalued. As rigorous assessors of value, they can readily decide which of their holdings, and indeed, which securities in the marketplace, offer the most inexpensive valuation and the best reward to risk and readjust their portfolios to reflect these updated assessments.
Warren Buffett has often cautioned that we should hold investments where it wouldn’t matter if the financial markets were closed for the next five years. Today, when market closure is at least an imaginable possibility, this advice is wiser than ever. Amidst turmoil, when nearly everyone’s time frame has been compressed to taking it one day at a time, value investors should remain focused on the long run, picking up the bargains — bargains with little downside and plenty of upside — that will work out over a several-year period.
Graham and Dodd remain our North Star to navigate by….
Klarman: Graham and Dodd have given us some 800 pages of reasons to be rigorous in our investing. Their diligence motivates us — demanding that no stone be left unturned in the quest for information, and no question unasked or unanswered in the desire to identify and mitigate risk. They are like silent sentinels, watching from the past to see if we have understood their lessons and successfully implemented them, as the road we must travel continues to twist and turn.
We navigate as best we can — and they remain our North Star. Value investing is at its core the marriage of a contrarian streak and a calculator. The strategy of buying what’s in favor is a fool’s errand, ensuring long-term underperformance. Only by standing against the prevailing winds — selectively, but resolutely — can an investor prosper over time. But for awhile, a value investor typically underperforms.
You can only control your process and approach….
Klarman: Value investors have a perspective that allows them not to suffer these interim losses, but to relish or at least appreciate them — because interim price declines allow an investor to average down, to buy more at an even better price, which results in much greater profits over time than if prices had not declined at all.
It is critical that you remind your clients, your investment team, and, as often as necessary, yourself, that you can only control your process and approach — that you cannot forecast the vagaries of the market, which in any case are an opportunity and not a problem for value investors. And then you should invest, comfortable that you’re doing the right thing, indifferent if you lose your short-term oriented clients — who will never understand what you do, or how they are their own worst enemies — and confident that when the dust settles and the crisis passes, your steadfastness and discipline will have added more value than any other approach.
And the pressure builds to change during poor performance.
Klarman: This point about controlling your process is absolutely crucial. James Montier, SocGen’s market strategist, pointed out in a recent piece that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the response again and again was that the competitor was focused on the process, not on the outcome. The way to maximize outcome is to concentrate on the process.
Montier points out that psychologists have long been aware of a phenomenon known as “outcome bias”. This is the tendency to judge a decision differently based on its outcome. For example, if a doctor performs an operation and a patient survives, the decision is rated as significantly better than if the same operation fails and the patient dies.
According to Montier, during periods of poor performance, the pressure builds to change your process. But so long as the process is sound, this would be exactly the wrong thing to do.
It is crucial to have, and maintain, a sound process….
Klarman: It’s so easy for one’s investment process to break down — and process is everything in investment firms. And today, many firms have a broken process. When investors worry about what a client will think rather than what they themselves think, the process is bad. When an investor is worried about their firm’s viability, about constant redemptions, about avoiding loss to the exclusion of finding a legitimate opportunity, the process will fail. When one’s time orientation becomes absurdly short-term, the process is compromised.
When tempers flare, when recriminations abound, when second-guessing proliferates,the process cannot work properly. When investors worry about the good of the firm or its publicly-traded share price rather than the long term best interest of the clients, the process is corrupted. When the process is broken, you can’t invest well. It’s hard enough to invest well when the process is good. So it’s crucial to have a sound process that will enable you to perform this difficult task with intellectual honesty, rigor, creativity and integrity.
Graham and Dodd teach us how to think about investing.
Klarman: Today, as we honor the legacy of Graham and Dodd, it is important to remember that value investing is not a perfect science. Rather it is an art, with an ongoing need for judgement, refinement, patience and reflection. It requires endless curiosity, the relentless pursuit of additional information, the raising of questions, and the search for answers. It necessitates dealing with imperfect information — knowing you will never know everything and that that must not prevent you from acting.
It requires a precarious balance between conviction, steadfastness in the face of adversity, and doubt — keeping in mind the possibility that you could be wrong. Ultimately, Graham and Dodd teach us not only about investing, but also thinking about investing. At the core of its wisdom are not mechanical rules to be blindly adhered to, but a way of thinking that allows us never to be blinded by rapidly changing facts or conditions. Mechanical rules are dangerous — requiring the world to be more constant and predictable and analyzable than it can be.
In this sense, Graham and Dodd’s principles are perhaps best utilized as a screen — a sieve to sort through the mass of securities to find those of greatest interest, with rigorous analysis and keen judgement then used to make the final investment decision.
You can find the original article by The Outstanding Investor Digest here.
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