Thursday, June 10, 2010

Comment Dissection

Most readers of this site's articles are value investors. As such, their comments or questions related to specific posts are of a value-oriented nature (e.g. "How much is that inventory really worth?" or "Will management actually proceed with that buyback?"). But occasionally, there are comments that clearly illustrate the difference between value investors and the rest of the market.

One commenter on a recent post made so many logical missteps (from the perspective of a value investor, that is; to him, it is we who make the logical missteps), that they are worth bringing up to show the type of thinking that dominates the market (after all, we are in the minority in our line of thinking).

The following quotes are from a single comment on a post about Acorn. (Since it is not my intention to call out or ridicule anyone, no info on the commenter is provided.)

"I guess I'm not strong at heart then" (The headline of the article stated a stock is so volatile that it is only for the strong at heart)

This particular snippet is not related to investing, but is a logical error nonetheless. When all A's (e.g. owners of this stock) are also B's (e.g. people with strong hearts), it doesn't mean that all B's are A's! You can have a strong heart and having nothing to do with the stock!

"Clearly ATV is a value trap."

In this business, nothing can be known to such certainty. In investing, you want to put the odds in your favour by employing large margins of safety. Beyond that, the only thing that is clear is that the future isn't! Becoming overconfident in your assessments can burn you.

"The company is not making any profit on its net assets value. There is a strong correlation between companies real profit ratio (returns over cost of capital) to its market cap/to net asset value ratio."

The commenter is probably right about this, but this is exactly what creates opportunities in the market. Some companies will lose money sometimes, but the investor should not rely on current earnings. Instead, the investor must consider the company's earnings power.

"Companies trading below its investment capital do so because they deserve to."

This is the argument that the market prices everything correctly at its intrinsic value. If this is the case, there is no reason for anyone to do any research. But if nobody did any research, how would market prices be correct? Arguments that stocks are correctly priced prompted Warren Buffett to quip that it has worked in his favour that his competition doesn't think it helps to even try!

"They don't actually earn any profit on that investment capital. Take a closer look. ATV: Stockholder equity around 200M plus a minor debt capital of around 3M, but with the 200M (or so) capital at its disposal EBITs are approx -5M. Well, a company cannot be a value investment if its destroying its investment capital at that rate."

Market participants tend to extrapolate trends into the future. But this is an activity that can cause great losses. Rather than focusing on current earnings or earnings trends, value investors view buying a stock as they would a stake in a private business. If a company with readily discernible assets (e.g. real estate, cash, reliable A/R) of $200 million is selling for $100 million, the buyer is getting a good deal. Not all such investments will work out; sometimes managements will make poor investments and blow much of that capital cushion. But the margin of safety is present to put the odds in the buyer's favour.

Of course, almost all investors think their line of thinking is correct. But we can't all be right. Value investors may be just as out to lunch as the next investing style. But one of the most convincing arguments of its proficiency is this article, written by Warren Buffett.


Ankit Gupta said...

"Becoming overconfident in your assessments can burn you."

Fully agreed.

If we go into an investment and are excited about having found a great/cheap deal, then we feel pretty proud. While we do that, we should realize that there are risks in every situation, and if we aren't seeing those, we missed something.

I'd say my best investments have been the ones I was most cautious about and most careful with in terms of how much of my portfolio was bet on them. There is a strong discipline needed from investors to avoid a lot of bad investments.

Saj - have you read Reminiscences of a Stock Operator?

Saj Karsan said...

Hi Ankit,

I have not. I take it you recommend it tho. I'll take a quick look.

Ankit Gupta said...

Saj - it's a classic investment book that every investor will benefit from. A lot of what you've written shows that you understand many of the issues brought up in the book, but the format is very easy and quick to read - you'll enjoy it :)