- Bargains can be found through book value, special situations, 52 week lows, merger arbitrages, bankruptcies, etc.
- It’s necessary to be a contrarian to be a value investor, though it might be painful for a while.
- With experience, it will take less and less time to assess a stock and whether it has the potential to be a good investment.
Last week we discussed Klarman’s view on the best business valuation methods. You can find the article here. Today we’ll discuss his approach to investment research.
Studying fairly priced securities won’t get you far because you’re competing with thousands of others who have researched those companies and, especially in the current market environment, if there is anything worth owning, it will probably be expensive. Therefore, to find bargain investments, an investor has to look where others aren’t looking or refuse to look.
Where To Look For Bargains
It isn’t possible to find good investment ideas by following the crowd as when something is well known, there’s a high probability that what’s good about it is already priced-in to the stock. Klarman, as a value investor, mainly focuses on three kinds of investment opportunities: stocks selling at a discount to liquidation value, rate-of-return situations, and asset-conversion opportunities.
In order to find stocks selling at a discount, Klarman suggests using stock screening tools, but be sure to re-check the output of the screen with the actual data on financial statements. I agree with Klarman as often I find that the data on various databases is wrong, especially for less followed stocks where bargains are easier to find.
Rate-of-return situations include mergers, tender offers, and complex securities while asset-conversion opportunities can be found with bankrupt stocks, recapitalizations, and exchange offers. Some legal knowledge is required in such situations, but when a good investment is found there, it’s usually one with low risk and a high return.
Further, Klarman suggests looking at stocks that are at their 52 week lows in order to find research ideas as often a stock reaches a 52-week low simply because of overselling. A good site to look for such opportunities is Nasdaq’s 52 week high and low page. Interestingly at the time of this writing, there are 130 stocks at 52 week highs and only 38 at 52 week lows. A clear indication of a late stage bull market.
Another place to look for bargains is where institutions aren’t allowed to invest. This includes small caps, some foreign stocks, spin-offs, stocks priced below $5, stocks that trade with low volume, stocks that don’t report financials quarterly but semiannually or annually, and stocks at a depressed price due to tax loss selling.
All of the above are special situations and proper due diligence has to be made before investing because more often than not, a stock is cheap because it is in trouble. When you find a cheap stock that isn’t in trouble, you’re on to something.
Apart from the increased necessary due diligence, value investing also requires you to be a contrarian.
Value Investing Is Inherently Contrarian
Let’s face it, if a stock is cheap, it’s because the vast majority of investors aren’t attracted to it or are even appalled by it. Such herd behavior often exacerbates the cheapness of a stock as investors look to get rid of the asset as fast as possible.
Great examples of such behavior are the two mining stocks sell-offs in the last decade. The 2009 sell-off can be rationally understood as the financial crisis pushed the value of all assets down. The January 2016 sell-off was irrational because commodity prices were at unsustainably low levels where the biggest fear factor was China slowing down. Many don’t understand the fact that even if China slows down to just 4% economic growth, it would still be growing, as would its demand for commodities, etc. Mining stocks have recovered during 2017 as commodity prices have increased. Those who had the courage to be contrarian in January 2016 made excellent returns.
Figure 1: Did you have the courage to invest in the downturns? Source: Investing.com.
On the contrary, if a stock is favored by the investing community, it for certain won’t be cheap as it will probably have a high price earnings (P/E) ratio. Investors usually prefer such stocks to the above described opportunities that arise when there is blood on the street.
A good example of a favored company is WD-40 (NASDAQ: WDFC). You probably have some of their products in your garage and it’s a well-managed, profitable company. However, the company’s stock price has quadrupled since 2009 while its revenue has only increased 30%.
Figure 2: WDFC has really been in the markets favor. Source: Yahoo Finance.
Therefore, Klarman suggests buying stocks when the herd is selling as then the price of a stock can fall well beyond reason. However, Klarman also warns that being a contrarian will likely lead to initial paper losses because it’s impossible to time the behavior of the herd and it might take some time for the value to be recognized. On the contrary, the herd is usually right for a period as a favorite stock constantly attracts new investments which increase its price. As shown above in the WDFC chart, the period in which herd investors can be right and contrarians wrong can be very long.
WDFC’s stock was rationally valued up until 2013 when its P/E ratio jumped from 20 to 30 and the stock price from $50 to $75. However, the stock continued to grow and even reached $125 in July 2016. It took almost 4 years for the stock to stop growing even though its valuation was above 30 the whole time This is a great example of herd strength.
For Klarman, it all boils down to assessing risks and rewards. Being a contrarian lowers your long-term risks and increases your returns, while following the herd lowers your long-term returns (WDFC’s P/E ratio of 30 implies a 3.3% long term yearly return) while it increases the risks (WDFC would be at $53 if valued fairly with a P/E ratio of 15).
Just a closing note on WDFC. The company is spending more money on dividends and buybacks than what it actually earns, and its debt to assets percentage went from 28% in 2011 to the current 63%, while its book value declined from $12.29 to the current $9.21 per share. The market is obviously neglecting the risks coming from increased debt and irrational capital allocation, and is focused on short-term metrics like growing earnings per share due to expensive buybacks.
How Much Research & Analysis Are Sufficient?
The answer to this question is one many of you that have lives will like. Klarman states that the initial 20% of the time spent on analysis provides 80% of the essential information about an investment, while the remaining 80% of time spent has diminishing marginal returns.
Such a statement has to be taken with two grains of salt. Not many investors have been researching stocks every day for the past few decades like Klarman had, therefore it might take more time for an average investor to properly analyze a stock and he might find important information at the end of his research. As for myself, 15 years of experience, tens of thousands of financial reports read, and a Ph.D. on how changes in accounting variables influence stock risk have certainly improved my research speed as I immediately know where and what to look for depending on the country, sector, and stock.
Therefore, the more experience an investor has, the closer they will be to Buffett’s level where it usually takes him no more than five minutes to know whether an investment could be a good one or not.
Additionally, Klarman suggests looking for investments where there isn’t enough information to make a clear decision. For example, in January of 2016, there wasn’t enough information to determine when commodity prices would recover, but there were plenty of stocks that had more cash than what their market capitalization was. Such a situation provides a large margin of safety and justifies an investment no matter what happens in the future.
Certainty and precision is something investors shouldn’t try to obtain while investing in stocks. It’s exactly the opposite, high uncertainty provides the best returns as long as the risk reward puzzle is skewed toward the reward side.
For Klarman, a very important indication that a stock is undervalued is when insiders increase their buying activities. Insiders can sell their stocks for whatever reason—like buying a new house, paying for college tuition or taxes, retiring, etc.—but there is only one reason why they would buy. That reason is obvious, they expect good things to happen and find the current stock price cheap. There are many platforms where an investor can track insider buying and selling activity these days, and companies are also required to disclose such activities.
A distinction has to be made here, there is a very important difference between the management buying for its own account, and merely doing buybacks by using the company’s money. Most of the buyback activity is done with the short-term purpose of increasing the price of a stock in order to get as much value as possible from stock option compensation schemes. Such a strategy works as long as everything goes well, the company can easily borrow money and margins are high. However, the quality of many companies deteriorates as their debt piles up and no effort is given to improving operational efficiency or growing organically. The next recession will show how costly the extreme buyback activity has been that the current corporate management has been doing as they’re paying whatever price for the companies’ stocks, clearly destroying long term shareholder value.
Figure 3: As stock prices have increased, buyback activity has intensified. Source: FACTSET.
Research is essential for investing. Without it, the process is more like betting. What’s also important is that the research is constant because you never know when an opportunity might arise.
In the current environment, it’s extremely difficult to find bargains. A clear indication of this is the fact that Berkshire Hathaway (NYSE: BRK.A, BRK.B) has $79 billion in cash sitting on its balance sheet. This also means that the large amounts of money flowing into U.S. stock ETFs are doing the opposite of what Warren Buffett is doing. While others are greedy, he is standing on the sidelines opportunistically waiting for panic to come and create bargain prices.
Klarman concludes chapter 9 by confirming that we can’t expect investment success without high-quality research performed on a continual basis. Such research will allow the investor to recognize and take advantage of opportunities when such arise.
Keep reading Investiv Daily as next week we’ll discuss chapter 10 in order to understand how to look at catalysts, market inefficiencies, and institutional constraints.