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Grahamites
Grahamites
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What I Learned From Arnold Van Den Berg - Part 3

Practicing discipline: always think about the worst case scenario and margin of safety

April 16, 2020 | About:

Arnold Van Den Berg (Trades, Portfolio) is the most self-disciplined person I know. In life, his self-discipline has led to physical and mental health. In investing, his self-discipline has been a key factor contributing to investment performance for more than 45 years.

In this article, I'll share some thoughts on how Van Den Berg thinks about discipline in the investment world.

Discipline in investing means always thinking about the worst case as well as disciplined buying and selling. I still remember the response I got back in 2012 from one of Century Management’s analysts after I sent my JC Penney (JCP) analysis to Van Den Berg and his research team (this was prior to my joining his firm). The analyst said he was more concerned about whether JC Penney was going to survive in 10 years than whether the valuation was cheap. That was the first time I got a taste of what discipline means in investing.

After joining Century Management, analyzing worst case scenario and margin of safety became part of life. In every single idea generation meeting, Van Den Berg always insists on going through two important items – worst case scenario and margin of safety. This is part of Century Management’s culture in the research department. It was also one of the most challenging aspects of my job when I worked for Van Den Berg. In fact, looking back, one key lesson I have learned under Van Den Berg’s mentorship is that “the worst case scenario has a higher probability of happening than expected, and when it happens, it’s almost always worse than expected.”

I can give many examples of how discipline has helped Van Den Berg’s decision making. Back in 2015, I was assigned to analyze IBM (NYSE:IBM) and spent a few weeks on the company. It looked like IBM’s traditional businesses had declined for many consecutive quarters, while the “strategic imperatives” had impressive growth and had become a larger part of the business. IBM was also paying a good dividend and buying back its shares aggressively. It was trading at just a little less than 10 times its 2015 adjusted earnings. Not to mention, Warren Buffett (Trades, Portfolio) was betting big on the company. There was a lot to like about IBM’s stock at that price.

When I held a discussion with Van Den Berg on the stock, he asked me what I thought the worst case was and how likely it would be to hit the worst case. I said based on my analysis, IBM was already pretty cheap. In what I thought was “extreme cases,” IBM may trade down to eight times adjusted earnings, but that was unlikely because of the many aforementioned positive factors. We should initiate a position right away. Then, Van Den Berg said that in his 40 years of experiences, even a company as strong as IBM very often did trade at 8 times earnings if there’s no growth. He suggested we wait for a better price. Being young, inexperienced and restless, I was actually disappointed that he wouldn’t buy IBM at 10 times earnings.

A few months after the meeting, IBM announced yet another very disappointing quarter, and the stock traded down to less than 8 times adjusted earnings. On my drive to work, Van Den Berg called me and told me that the stock had been beaten down pre-market and he was about to have the trading department to place the buy order, but he wanted to check with me first. I said “Arnold, you were right. The worst case does happen more often than I thought. Now it’s a better time to buy.” Century Management eventually made more than 50% on IBM, including dividends, in less than two years. Had Van Den Berg bought it at the price I suggested, the total return would have been less than 30%.

Another example is DaVita (NYSE:DVA), which was called DaVita Healthcare Partners a few years back. It was a mistake I wrote about in the past. When I first pitched the idea together with a colleague, again being inexperienced and ignorant, I thought the value was obvious. It turned out Van Den Berg didn’t like the idea at all. DaVita was highly leveraged after the acquisition of Healthcare Partners. The dialysis business looked stable but also complicated. It was cheap on a DCF analysis, but the assumptions behind the DCF model are not the most conservative assumptions, in his view. He said a lot could go wrong with DaVita, and it doesn’t appear there’s a sufficient margin of safety baked into the buy price we suggested. Less than two years later, everything that could have gone wrong did go wrong with DaVita. The worst case was, again, worse than I expected.

After a few of those mistakes, I had a long conversation with Van Den Berg. He told me that in his early years, he had a client who absolutely could not afford any permanent capital losses, so what he did in that client’s account was to only make purchase decisions when a stock was so beaten down that the downside was very limited. That meant he would only make a few trades in that account. After a few years, he reviewed the performance of all the accounts he managed and found out that this client’s account had performed much better than other accounts because he almost always bought at or close to the worst case prices. This early experience shaped how he approached purchase decisions.

He also taught me that in his experiences, no matter how much he thought he knew about the business, there’s always "something he would find out later that he didn’t know" and "something he didn’t know that he didn’t know." So you always want some extra margin of safety to protect your ignorance as well. For a simple business, there might be two or three important things you don’t know, so you might need 20-30% extra margin of safety. But with a business as complicated and leveraged as DaVita, there could be five or six important things you don’t know, so you may want at least 50-60% extra margin of safety.

Most value investing gurus are known for their discipline as well. However, given his holocaust experiences, Van Den Berg probably has a deeper understanding of what worst cases look like, both in life and in investing. It is this almost instinctive sense of worst case scenario and margin of safety that makes van Den Berg one of the greatest minds in investing. I was really lucky to be able to learn this wonderful and important investment lesson from him.

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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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