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Stepan Lavrouk
Stepan Lavrouk
Articles (74) 

Bruce Berkowitz on Book Value and Momentum Investing

Why balance sheets trump income statements and why trend-following is a biological artifact

February 19, 2019 | About:

Fund manager Bruce Berkowitz (Trades, Portfolio) is a well-known value investor with much to say. In an illuminating interview, he explained his thinking on a number of issues: the relative importance of balance sheets compared to income statements, liquidation values and the flawed psychology of momentum investing.

Balance sheets are king

“I think that there are less ways to cheat on a balance sheet than there is on an income statement. So here’s the problem with the income statement: say you’re an automobile manufacturer and you make billions of dollars of profit. And then after you’ve made the profit you realise you have to invest that money for a new product line in order to stay competitive and to still sell the same number of cars. So it looks like you made the profit but you really didn’t make the profit, you had to put it into an investment-intensive operation to stay competitive. So, did you really make that money? I don’t know, I would say no.”

In other words, earnings do not accurately represent the true present, or future, value of a business. There are many ways in which an income statement can be gamed, whereas is it trickier to mislead investors reading a balance sheet, without engaging in outright fraud.

“We view book value in many cases as a liquidation value, and the idea is that if we can buy below liquidation value, then we take care of the downside and the upside will look after itself. We’re very much focused on the idea of ‘what’s the worst thing that can happen, and are we still going to make money?’ and we don’t think too much about how much money we are going to make if great things happen.”

This is somewhat similar to what Warren Buffett (Trades, Portfolio) refers to as "cigar-butt investing" -- bargain-basement hunting for average or below-average companies priced extremely cheaply. Of course, it is theoretically possible for a good company to be selling at or around book value, but in the present day this is almost impossible to imagine in practice. Interestingly, the Oracle of Omaha does not advocate this approach, something we discussed in a previous piece. Nevertheless, the underlying principle of focusing on the worst-case scenario when evaluating an investment and not worrying about all the good things that might happen that Berkowitz presents is applicable to all types of investing.

The problem with momentum investing

“Why do so many people make the same mistake over and over again, and how could so many people be wrong at times when it comes to investing? One of the reasons is to do with biology and the way that your brain is wired, from prehistoric days. We use all these kinds of shortcuts - so for example in the Stone Age, if you saw a bunch of your buddies running really fast in the opposite direction it was usually a really good idea to run with them, so you weren’t some animal’s breakfast... Momentum: follow the trend, the trend is your friend. And people use that as a shortcut with investing, especially if you have a job, and only have so much time to invest and you need these shortcuts to cut through the issues. People use price as a proxy for worth, and many times it isn’t, which gets people into a lot of trouble.”

As Berkowitz went on to say: "There’s no such thing as a free lunch -- it either ain’t free or it ain’t lunch." Individuals chasing red-hot growth stories based solely on the expansion of speculative interest are destined for disappointment sooner or later. There are deep psychological and biological reasons for wanting to follow the crowd -- fear of missing out on a great opportunity, for instance, or the circular belief that so many people cannot be wrong.

The shortcuts that served us well 100,000 years ago do not apply as well to the problems of the present day, so the diligent value investor must always be on the lookout for signs of such sloppy thinking in his or her own mind.

Disclosure: The author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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