Like any value investor, Seth Klarman (Trades, Portfolio) looks for opportunity in instances where the market is acting emotionally rather than rationally. But what do these opportunities actually look like? Klarman provided a list of these scenarios in the 2009 letter to investors of his Baupost Group:
“When securities decline, it is crucial to distinguish, as possible causes, legitimate reaction to fundamental developments from extreme overreaction. At Baupost, we are always on the lookout for such overreactions, whether due to the disappointing earnings of a failed growth stock, a ratings downgrade of a bond, the deletion of a stock from an index or its delisting from an exchange, or the forced sale resulting from a margin call. Usually, fearful overreaction equals opportunity”.
The last two examples should be of particular interest to stock investors. Let’s first talk about companies that are deleted from a stock index. Most of the more well-known indexes are weighed on a market capitalization basis, which means that the funds that follow it hold the companies in question only as long as the market cap is high enough to merit inclusion in the index in the first place. If the company falls out of the index, that tends to set off a chain reaction of selling. Crucially, this selling has nothing to do with the underlying fundamentals of the company, apart from the fact that its market cap fell below some arbitrary line.
Similarly, the forced selling of an asset due to a margin call of some large institution also has little to do with the asset itself. Oftentimes, a stock will be falling for no other reason than the fact that its previous holder is being liquidated. In other cases, it may be a pension fund which is rebalancing its portfolio - it has a mandate to execute and does not care about the price at which the sale is occurring. These are exactly the kinds of windows that value investors should be trying to exploit.
That said, if something is dirt cheap, there is sometimes a reason that’s better than “everyone else is too irrational to correctly value this”. When selling pressure intensifies, those that buy need to be prepared for the possibility (and, indeed, the probability) that the selling will continue:
“Throughout 2008, prudent investors sifting through the rubble for opportunity were repeatedly surprised by the magnitude of the selling pressure, and, in many cases, by the extent to which the deterioration in business fundamentals has come to justify the lower market prices. Many forced sellers, through their early exits, inadvertently achieved better outcomes than the value-oriented bargain hunters who bought from them”.
There are two lessons to be learned here. Firstly, just because something is cheap does not mean that it is a great bargain. After all, markets are efficient much more often than they are inefficient. Secondly, it is almost impossible to nail down the exact bottom price of a security. Anyone who wants to be a value investor better prepare for their portfolio to continue cheapening before it improves.
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