Previously, I discussed the difference between good and bad investors as defined by Seth Klarman (Trades, Portfolio). In short, he believes good investors trust their own judgement, whereas bad ones look to the market for advice. I also noted that a competitive edge is rarely found on the surface - in order to find real value opportunities, you are going to have to do some digging.
Klarman’s 2007 remarks from a speech at the Massachusetts Institute of Technology were insightful because he actually pinpointed the types of places that value investors should be looking at for these opportunities.
Where opportunities lie
Klarman believes that market inefficiencies generally arise in businesses and securities that are difficult to understand. Most people like growth stories, and they especially do not like scenarios that have any sort of legal trouble attached to them. As the guru noted:
“They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil. Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance.”
There’s no such thing as a free lunch. If something looks too good to be true, then in 99% of cases, that’s what it will turn out to be. The market can be irrational, but most of the time it tends to be pretty efficient, so there has to be a good reason for a cheap asset to be cheap. Klarman’s example of a company with legal troubles surrounding it is a good example. Now obviously it takes a certain amount of legal acumen to figure out whether the panic in this case is overblown. But this is exactly the kind of hard work that value investors do when looking for bargains.
There are other sources of opportunity too. When I worked as a trader, we would see price shifts all the time at the end of the quarter. This is because there are pension funds and other large institutions that follow a particular strategy that requires them to rebalance their portfolios at the end of every quarter, regardless of whether buying or selling the stocks in question is a good idea in a vacuum. When you’re managing billions of dollars, the relative value of a stock that comprises 0.5% of your portfolio matters less than the risk of the portfolio as a whole, so there’s nothing wrong with this from the pension fund’s point of view. However, this does also create opportunities for value investors.
Klarman mentioned some other sources of value, such as when institutions who can only own dividend-paying stocks are forced to sell them when a dividend is not declared, or when a stock is removed from an index or when selling occurs for tax reasons. In short, there are many reasons why companies end up selling for less than they are worth, which is something value investors should pay close attention to.
Read more here:
- This Is the Difference Between Good and Bad Investors
- Joel Greenblatt: How to Handle the Emotional Aspects of Investing
- What's Up With the New Trade Deal?
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