Having a proper margin of safety is essential for any value investor. However, is there a point at which this margin can be too big? How much is too much? In a question-and-answer session at the Wharton School of Business in April 2018, Oaktree Capitalās Howard Marks (Trades, Portfolio) discussed the limits to conservative investing, and how value investors should be willing to catch falling knives.
Itās not easy, but it is simple
Proper investing can be distilled to a single phrase: buy low, sell high. In essence, you need to calculate what an asset is worth, and to buy it for less than that. Now, in practice, this requires a lot of thinking and intermediate steps, but the bare bones of the process are quite straightforward. Itās not easy, but it is simple, as an old football coach of mine used to say.
Marks explained that the process is really no different when it comes to his arena - distressed debt investing:
āYou look at a company, you figure out what it could make in a normal environment and you figure out what that company would be worth to a strategic buyer, once its problems are largely resolved and once the capitalization has been restructured. Then you think about how that value will be divided up among the various classes of claimants and you figure out what a piece of a claim is worth and you see if you can buy it for less. And if you can make those judgements on the basis of conservative assumptions and still end up with good room for profit, then thatās a source of margin for error.ā
Although the kinds of securities Marks buys are ones that the ordinary retail investor will probably never interact with, his overall approach is readily generalizable to stocks - he uses conservative assumptions in his valuation to ensure that he is buying at a big discount to intrinsic value.
Too conservative is no good
However, being too careful is not necessarily a virtue. At some point, you have to factor in a certain level of optimism. As much as value investors like to say they are more rigorous than growth investors who extrapolate out the earnings of high-flying tech stocks, the reality is that at a certain point every investor has to take a leap of faith. This is what Marks means:
āItās not true that āthe more conservative the better,ā because you can get to the point where you make assumptions that are so conservative that youāll never lose money but it will give you a target buying price that youāll never buy anything! So you have to kind of gut it out and be willing to include some optimism, or else youāll never get to buy anything.ā
Itās our job to catch falling knives
Ultimately, the best bargains will always have a somewhat uncertain future; thatās what makes them bargains:
āMy vision is that when the stuff hits the fan and thereās blood in the streets, most people look like this [raises hands]. They say 'weāre not going to buy until the knife stops falling, until the dust settles, until all the uncertainty has been resolved.' But the trouble is that once that happens, then the price will have rebounded. So we want to buy at a time of upset and while the knife is still falling. I think the refusal to catch a falling knife is a rationalization for inaction. Itās our job to catch falling knives, thatās how you get bargains. But you have to do it carefully.ā
Read more here:
- Warren Buffett: Do Not Part With Your Crown Jewels
- Think Like Warren Buffett: Buying Stocks Is Like Buying a House
- Everyone Is Just Winging It: Howard Marks on Why Listening to Forecasters Isn't Helpfulāā¹
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