Here’s a great interview (below) with Howard Marks at the Wharton School of the University of Pennsylvania (2018).
Marks was asked his thoughts on distressed debt investing, margin of safety, and catching falling knives when evaluating prospective investments. Here’s his response:
Marks: You know there’s only one intelligent form of investing and that’s to figure out what something’s worth and try to buy it for less. Distressed debt investing is not different in that regard. We have to do the same thing.
I’ll exaggerate the simplicity but you look at a company, you look at the business, you figure out what it could make in a normal environment, and you figure out what that company would be worth generally thinking to a strategic buyer once its problems are largely resolved and once the capitalisation has been restructured. Then you think about how that value will be divided up among the various classes of claimants and you figure out what a piece of a claim is worth. And you see if you can buy it for less.
So if you can, if you can make those judgments on the basis of conservative assumptions and still end up with good room for profit then that’s the source of margin for error.
I think that the margin for error comes primarily from being able to use conservative assumptions and then still be looking at a generous rate of return. Now its variant, but before I stop I must say that it’s not true that the more conservative the better. Because you can get to the point where you can make assumptions that are so conservative that you’ll never lose money, but it will give you a target buying price which is so low that you’ll never buy anything.
You have to kind of gut it out and be willing to include some optimism or else you may never get to buy anything.
You mentioned catching falling knives, and my vision is that when the stuff hits the fan and there’s blood in the streets most people go like this, they say well we’re not going to buy until the knife stops falling, until the dust settles, until all the uncertainty has been resolved. But the trouble is that once that happens then the price will have rebounded.
So we want to buy at a time of upset and while the knife is still falling and I think the refusal to catch a falling knife is a rationalization for inaction. It’s our job to catch falling knives, That’s how you get bargains. But you have to do it carefully.
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