These are challenging time to be an investor. The Coronavirus pandemic has devastated the global economy, but despite this headwind, many stocks, specifically stocks in the tech sector, have risen to nose-bleed valuations.
Some of these valuations make sense. Others don't. The challenge is trying to work out which companies deserve their valuations and whether or not the world has now entered a "new normal" for the stock market. Do company valuations no longer matter now that central banks have seemingly removed all precautions?
Unfortunately, we're only likely to find out the answer to this question when it's too late. In these times of uncertainty, I always find it helpful to go back and review the advice of highly regarded value investors such as Seth Klarman (Trades, Portfolio) during similar periods.
For example, in the late 1990s, the stock market was gripped by the tech bubble. As Klarman described the environment in his December 1999 letter to investors, "we are navigating through an unprecedented market environment, where fundamental analysis is thrown out the window and logic is turned on its head."
Against this backdrop, Klarman wrote that his hedge fund, Baupost, would not be changing its investment strategy to try and keep up with the crowd:
"Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today's financial climate. Our answer, as you might guess, is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success."
He went on to add that the firm's primary aim above all else was the preservation of capital. This approach, he continued, demanded discipline and patience. Klarman said he also had to make sure the fund was never "swept up in the enthusiasm of the herd." He proceeded:
"Patience is required to wait for just the right opportunities, avoiding the pressure to make investments that don't meet the most stringent criteria of quality and undervaluation, and then to hold on."
What Klarman was trying to explain here was the basic concept of sensible investing. Klarman has always followed a value style, but that has never lead him to limit his investment holdings.
Value investing for Klarman is buying assets and stocks trading at a discount to his estimate of intrinsic value. There's no one-size-fits-all formula one can use to determine intrinsic value. Trying to use simple metrics such as the price-book or price-earnings ratios is lazy and will likely throw up a misleading result. Every asset is different, and they all deserve different methods of valuation.
Klarman's strategy's central core has always been a desire to eliminate the risk of permanent capital impairment. On top of this, he wanted to buy stocks that he believed were cheap. This strategy should be the core of any investors' strategy. Buying stocks that one thinks are cheap with minimal risk of a total loss.
That's what we can learn from Klarman's approach in the late 1999s. No matter what the rest of the market is doing, sticking with a strategy you're comfortable with is essential. Other market participants may be making truckloads of money around you, but that does not matter. Investing in something you don't understand is the easiest way to lose money. In times of uncertainty, adherence to this strategy is more crucial than ever.
Disclosure: The author owns no share mentioned.
Read more here:
- Thoughts on the Margin of Safety and a Company's Profitability
- A Closer Look at Seth Klarman's SPAC Holdings
- Warren Buffett on Business Mistakes and How to Avoid Them
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