In a previous piece discussing an article written by Seth Klarman (Trades, Portfolio) about Warren Buffett (Trades, Portfolio), I singled out his explanation for how Buffett’s idea of risk-aversion differs from that of many professional money managers, and how short-termism creates perverse incentives for investment professionals to chase after expensive stocks that everyone else owns. I thought that was an interesting theme to explore further. Here are the factors Klarman believes drive this short-sighted behavior.
Value investing is about buying what doesn’t work right now
Klarman wrote the article in 1999, and his use of Dell (DELL, Financial) as an example very much shows this:
“Investors tired of underperforming don’t sell Dell Computer (no-one, it seems, sells Dell), which they love for what it has done for them, no matter how expensive it has become. It is so much easier for them to sell whatever has recently disappointed investor expectations, no matter how inexpensive it has become. Mutual fund managers, desperate to put cash to work, don’t buy what is cheap but what is working, since what is cheap by definition hasn’t been working.”
It is tempting to write off this behavior as pure foolishness. On closer examination, however, there are more pervasive forces at work here. For one thing, such "growth first" strategies often do outperform the market for significant periods of time, which (temporarily) vindicates the thesis. For another, these managers that Klarman is talking about often face immense pressures, both from the clients and bosses, to do what everyone else is doing. Value investing will always involve buying something that "doesn’t work" at some moment in time. For many portfolio managers, such a move could constitute a fireable offense.
“It seems that as long as there are inflows into the hands of institutional investors, there will be a telescoping of investment into the several dozen names that have reliably reported quarter-by-quarter earnings growth and almost constant share-price appreciation. It seems obvious, but is actually a slippery and very dangerous slope. When stocks are rising for no better reason than that they have risen, the greater fool is at work.”
In other words, the self-reinforcing behavior of so many institutions following each other’s lead eventually becomes a self-fulfilling prophecy - for a while, at least. The problem for the investor, or rather, speculator, attempting to make money off of such stock price movements is that it becomes almost impossible to know when to buy or sell a stock. Day traders claim to know the answers to these questions by studying order flow and momentum in the buying and selling of a particular stock, but the success rates among such operators is quite low. Real investors, who look at the fundamental drivers behind price, can avoid such pitfalls altogether:
“An investor who initially purchases based on value knows to buy more when an already undervalued stock falls and to sell when it becomes fully valued. An investor in an Internet stock or in the extraordinarily expensive shares of a very good company has no idea what to do when the price moves up or down. This creates a serious dilemma for the great majority of investors and a real opportunity and a real opportunity for a few”.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: What Warren Buffett Did During the 1973-1975 Bear Market
- WeWork's Backers Have Had Enough of Its Eccentric Founder
- Warren Buffett on Junk Bonds, Part 2
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