“Value… is not enough. Buying low is a start… but you need the patience, discipline and grit to buy lower, and still lower, if the opportunity presents itself, shutting out the extraneous noise coming from within the market and over the airwaves.”
I think this quote relates to what I was talking about in my recent article discussing investing versus speculation:
“An investment, by Warren’s definition, is the act of looking at an asset and determining to lay out some money now to get some more money back later on. Logically, this requires a couple of things on our end: we must know the current amount to be laid out (easy enough to find), but we must also be able to estimate the amount of money to be recovered in the future (a bit more difficult). This requires in-depth analysis that focuses on sustainable competitive advantages and conservatively estimates the future cash flow generation of the business, while avoiding outsized attention on short term fluctuations that are beyond the company’s control and unrelated to the fundamentals in question (for example, commodity cost volatility); collectively, this information can provide the basis upon which one can confidently invest in securities backed by a sizeable margin of safety.”
Klarman lists three attributes that are required beyond the simple act of equity valuation; these are the characteristics that the successful investor must possess to capitalize on the market’s inefficiencies. The first on the list is patience; the problem, as many investors know, is that the market doesn’t particularly care about your thoughts on a company’s valuation, and won’t jump towards your estimate of intrinsic value simply because you decided to invest (unless your name is David Einhorn). Warren Buffett discussed this idea in a 2008 speech at the University of Florida:
“I have no idea where the market is going to go; I prefer it going down. But my preferences have nothing to do with it. The market knows nothing about my feelings. That is one of the first things you have to learn about a stock. You buy 100 shares of General Motors (GM); now all of a sudden you have this feeling about GM. If it goes down, you may be mad at it. You may say, ‘Well, if it just goes up to what I paid for it, my life will be wonderful again’. Or if it goes up, you may say how smart you were and how you and GM have this love affair. You have got all these feelings; the stock doesn’t know you own it.”
This is a fundamental part of value investing: irrationally, we expect that the market inefficiencies that allow us to find attractive investments will immediately revert to sanity once we put our chips on the table; this is pure fallacy.
This is critically important, and something that gives me trouble to this day: my issue isn’t committing to additional investments as prices decline; it’s moving too quickly in an attempt to snag the absolute low tick on the security. From my personal experience, I would simply suggest that investors spread out their purchases, such that they have the cash on hand to capitalize upon mispriced securities that become even more attractive after your initial purchase.
The next attribute Klarman discusses is discipline; by my interpretation, this refers to the changing dynamics surrounding an investment as time passes and an investor’s subsequent reaction to new information. Behaviorally, it’s difficult to remain unbiased after you commit capital, which likely causes you to view the company with rose tinted glasses: anything negative will be put into the “noise” category, and the positives will be the new talking points upon which you justify your investment. Like many people, I’ve had problems with this bias; to date, the best method I’ve found for limiting its influence is an investment journal/fact sheet, which lists the justification and price target for an investment, in addition to potential risks or catalysts that would require a reassessment of the position.
The final attribute Mr. Klarman discussed is grit; as defined by Merriam-Webster dictionary, grit is “firmness of mind or spirit; unyielding courage in the face of hardship or danger”. Grit, in other words, is conviction in your analysis, which may come in spite of a declining stock price and the subsequent bashing of the company by the talking heads; in this sense, grit has been best described by the father of value investing, Ben Graham:
“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” This unyielding courage is not based on faith; it comes from sound data and reasoning that is the basis for an investment, regardless of short term volatility.
Summing this all up, we can draw some logical conclusions:
1) Volatility and inefficiency is the friend of the value investor, and is that which creates opportunity in the first place; as such, the continuation of this volatility and inefficiency after our investment has been made is a simple fact of life.
2) For the value investor, a conservative estimate of intrinsic value is an absolute must; the only way we can be assured to stick by the conviction of our analysis and to capitalize upon an increasingly attractive stock price is with this information in hand.
3) In the context of capital allocation, the firmness of our conviction must be mixed with patience; the value investor must have the endurance to sit calmly and build a position over time, rather than overextending themselves in a short period of time simply because the price is 1% below where it was yesterday (I should be forced to repeat this daily to make up for my past inability to follow this rule). You don’t need to hit the bottom tick to attain attractive results; but you need to have the resources “to buy lower, and still lower, if the opportunity presents itself.”
Value, as Mr. Klarman says, is not enough. A keen focus on logical capital allocation in the face of volatility and noise is a necessity in the value investor’s toolbox; success, in terms of portfolio construction, is dependent upon a finely-tuned trio of patience, discipline, and grit.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.