In a recent interview with Outlook Business, value investor Bill Nygren (Trades, Portfolio) of the Oakmark Fund shared an important lesson that he picked up from Paul Tudor Jones (Trades, Portfolio) (bold added for emphasis):
There is a famous picture of Paul Tudor Jones (Trades, Portfolio) with a piece of paper on his bulletin board that says "Losers average losers." As value investors, we always want to believe that the stock is overreacting to bad news. A typical analyst report goes: This is a disappointing quarter, but my value estimate fell only 5% while the stock fell 15% so it’s a lot cheaper than it was yesterday. This led us to do a lot of research into our own ideas. When the fundamentals start deviating from what our analysts had projected, averaging down on those names tends to not work. It made us alter how we thought a little bit more.
If you're the type of investor who looks to buy high-quality businesses when they're dealing with short-term headwinds, you are bound to stumble across this scenario. Even with a concentrated portoflio, I've seen this a handful of times in the past three to five years. I could benefit from having a better plan when fair value estimates are moving lower; as Nygren suggests, that plan may be as simple as not averaging down when “opportunity” appears.
It’s a hard proposition for me to accept because the math is clear. If your fair value estimate falls 5% compared to a double-digit decline in the stock, the discount has widened. There's only one thing for a value investor to do: buy more. To suggest otherwise would be blasphemy.
But while that sounds good in theory, there are legitimate concerns about its effectiveness in practice. For example, studies have shown that analysts underappreciate (and insufficiently account for) new information in their models. They make incremental changes that stubbornly cling to their prior conclusions. Here’s how James Montier summed it up after analyzing the results:
They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly.
We suffer from the same biases. When we update our models and conclude fair value has fallen ~5%, there’s a good chance we're understating the damage. The new estimates are not unbiased conclusions; they are anchored (to some degree) to our prior assumptions. If we make an error in judgment, it’s likely to be in the direction that favors a higher FV estimate – and that’s a problem.
(This assumes that you conclude fair value has declined. But it’s not always that easy since we’re trying to distinguish between noise in quarterly results and what really matters – the assumptions that affect intrinsic value. But that’s a discussion for another time.)
The other issue I’ve run into is separating between small updates to the model and significant changes to the thesis. Consider what happened with Walmart (WMT) after management reset expectations in late 2015: Are materially lower margins an update to the financial model or representative of a fundamental change in the thesis? Accounting for the quantitative impact is easy; it’s the other considerations of such a development that are more difficult to handicap.
As I’ve encountered these situations over the years, I’ve moved to Nygren’s conclusion: buying more in the face of lower fair value estimates (even when the discount is widening) is a difficult game to play. It's something I've done with limited success, particularly in the short term.
In addition, I’ve become more concerned about “thesis creep.” I worry that buying more may impair my ability to objectively analyze the results when the next data point arrives. It would be foolish (and costly) to work under the assumption that I'm immune to these biases.
Sticking with the Walmart example, I eventually concluded that EBIT margins were unlikely to revert to historic levels. That was a development I had not expected when I first invested in the company (I thought we might see mean reversion over three to five years). As opposed to backing into a new thesis, I concluded it made sense to liquidate the position and “start over” if I felt the need to revisit a potential investment. Simply put, I decided that the validity of my original thesis was in question; as a result, the appropriate course of action was to sell the stock.
Conclusion
Dealing with declining fair value estimates requires a delicate balance between sticking to your guns and admitting when something material has changed. The exercise becomes even more difficult when you’re forced (or at least feel forced by outsized market movements) to draw a conclusion based on 90 days of financial results.
So what can we do? One solution is to avoid situations where you don’t have a good feel for whether the company’s current struggles are cyclical or structural. Obviously, that’s easier said than done. If you stay within your circle of competence, there will be certain instances when you can say more about the cyclical / structural split than the average investor.
That requires a real understanding of the business. You should be able to offer a detailed explanation of the short-term issues the company is facing – and why they’ll go away (timing is much more difficult to get a grasp on). If you don’t have a better appreciation for the bear thesis than the people betting against the company, that’s a bad spot to be in.
As always, I don't think this is the "right" answer. It's just an answer that works for me.
Disclosure: None.
