- A value investor should trade when a better bargain present itself.
- Liquidity is a key component of an investment and of a portfolio.
- Klarman’s advice is to stay in touch with the market to find opportunities, average down, and hold ten to fifteen stocks max for proper diversification.
We’ll continue with the analysis of Seth Klarman’s book Margin of Safety. Today we’ll discuss chapter 13, Portfolio Management and Trading.
I‘ve skipped chapter 11, Investing in Thrift Conversions, and chapter 12, Investing in Financially Distressed and Bankrupt Securities as I find those two topics a bit outdated. However, I will certainly come back to chapter 12 as soon as the economy gets close to a recession and more bankrupt investment opportunities arise. For now, I don’t really see the retail bankruptcies as a hunting ground for value investors because those companies are bankrupt for a reason and the low interest rate environment makes it unlikely that there will be any equity left after reorganizations.
Back to portfolio management and trading. Each of us has different investing goals, investment horizons, our risk appetite is different, the financial instruments used are also different, etc. Therefore, apart from finding a proper value investment, Klarman emphasizes the importance of appropriate portfolio management by introducing something controversial to value investors, trading.
It’s impossible to manage a portfolio without occasional trading. Investments change all the time, fundamentals can change, a stock price can increase, or interest rates can change. This makes the investment process a constant as investors have to balance between appropriate diversification, hedging decisions, managing portfolio cash flow, and liquidity.
How Important Is Portfolio Liquidity?
Klarman strongly advises requiring proper compensation for an illiquid investment. Liquidity allows us to change our minds and sell when we no longer think of the investment in the same way. Buying an illiquid asset doesn’t offer the opportunity to sell. Therefore, the longer the expected illiquid period is, the higher the compensation for illiquidity should be because the more time there is, the more things can go wrong with an investment, i.e. the risk is higher. For example, venture capital investors are faced with an illiquid period of uncertain duration and with an uncertain outcome for the venture.
Apart from portfolio liquidity, it’s also very important to think about the general market’s liquidity. When the markets are stable, it’s usually not a problem to sell or buy something. However, when the market panics, the liquidity that was present in the bull period quickly evaporates as sellers rush to sell while buyers wait for the price to get lower. To avoid getting trapped in an illiquid investment, it’s important to know your liquidity limits and invest accordingly.
There are several ways to deal with portfolio liquidity. Constantly adding new funds to one’s portfolio certainly helps as it enables an investor to hold onto certain illiquid investments that still have to appreciate, and allows them to not miss new investment opportunities, thus lowering the opportunity costs. Additionally, long term investors can certainly hold on to illiquid investments without too much stress, but they sure have to demand a high reward for the illiquidity.
Reducing Portfolio Risk
Investing isn’t just about finding good investments. Of equal importance is portfolio diversification, proper hedging, and the management of portfolio cash flow. Each investment carries its own degree of risk. However, the goal of portfolio management is to lower the total risk of the portfolio, even if the risk of individual investments is higher.
Appropriate diversification certainly helps to lower one’s portfolio risk. Klarman says that it isn’t necessary to hold a huge number of securities as ten to fifteen different holdings usually suffices for proper diversification.
Klarman is obviously against over-diversification and index funds as he thinks that knowing a lot about a few stocks is much less risky than knowing a little about many stocks. He is in line with Buffett by stating that one’s best ideas are likely to provide higher returns for the same level of risk than one’s hundredth idea.
Klarman uses the junk bond market of the 1980s to describe the risks of improper diversification. We can easily compare the 1980s overpriced junk bond market to today’s overpriced S&P 500. Many are being sold on that the S&P 500 is well diversified, but this is very far from the truth. Being well diversified doesn’t mean owning 500 holdings, but rather owning holdings that have different risks. A recession or higher interest rates will pull the whole S&P 500 down.
Market risk can’t be mitigated by diversification, but can be lowered through hedging.
Klarman describes how one can hedge by selling S&P 500 index futures if their portfolio mainly consists of U.S. large caps but also warns that hedging does come at a cost. However, what’s interesting to the sophisticated investor is that sometimes the actual hedge can be a good investment.
For example, back in 1990, Japanese stock market long-term puts were extremely cheap while the market was overvalued. Those who invested in such puts made several times their money.
The Importance Of Trading
The only thing important to the value investor is the price.
As we know, the market is irrational and sometimes overpays for a stock while sometimes there is the opportunity to buy something extremely cheaply. A value investor trades in order to take advantage of such opportunities.
For example, last year I was a buyer of Apple (NASDAQ: AAPL) when the price was below $100 as I found it an extreme bargain.
Figure 1: AAPL’s stock price performance. Source: Nasdaq.
As soon as APPL’s stock price went above $110, I started selling my position as the investment didn’t offer me the same risk reward opportunity as when it was below $90. I know the price is above $150 now and I missed a huge upside run, but that isn’t the point of value investing. Holding AAPL at $120 is much riskier than holding in at $90. In value investing it’s all a matter of price and risk.
Stay In Touch With The Market
As trading is the opposite of what many long-term investors advise, Karman is also contradicting many with the notion that a value investor has to follow what’s going on in the markets. This doesn’t mean trading on every uptick. Staying in touch with the market means taking the opportunities arising from the market’s irrationalities.
Today, as was the case when Klarman wrote his book, most market participants are completely ignorant of fundamentals. Therefore, stock prices are often pushed to incredibly euphorically high levels and incredibly low levels in market panics. Such irrationalities happen more often than you might think, and value investors should take advantage of such opportunities and trade around them.
A great example of how irrational prices can get is last week’s drop in the Brazilian stock market. Due to political uncertainties, stocks dropped on average 20%. The funny thing is that some stocks aren’t under any political influence and will continue to operate normally. Therefore, following the market allows us to buy things very cheaply more often than you might imagine.
Figure 2: The iShares MSCI Brazil Capped ETF fell almost 20% in one day. Source: iShares.
Buying: Leave Room To Average Down
Going back to the Brazilian example above, we can’t know whether there will be more political turmoil that will send the stock market even lower. Therefore, Klarman advises never buying a full position in a stock all at once. Buying a whole position in one buy might force you to helplessly watch the stock further decline while you don’t have any more buying power. Buying in small stakes allows the investor to average down in declining markets.
Averaging down is opposite to what most traders would advise, they’d instead tell you to sell the losers fast and stick to the winners. But when the fundamental value analysis of a stock shows it’s a great investment, a real value investor is extremely happy to buy more when stock prices fall. If you feel reluctant to buy more, you have been speculating and probably shouldn’t own the stock at all.
When To Sell A Stock
Buying is easy. When a stock trades below its fundamental value, you can’t go wrong because of the margin of safety. On the other hand, selling is a completely different story and the most difficult thing in investing.
As a stock appreciates, the margin of safety diminishes, and the risk increases while the potential return decreases. However, you can never know whether the stock will go higher or not, like in my AAPL situation described above.
There are many rules on when to sell, but Klarman’s rule is that: “all investments are for sale at the right price.”
The decision to sell is also influenced by what else is there on the market. If you find a great bargain, it would be wise to sell a stock that hasn’t yet fully realized its value in order to exchange it for a better bargain. If there aren’t many bargains around and a holding is still trading below its real value, then it doesn’t make sense to sell.
Klarman defines using stop-losses as a crazy activity and not at all a risk limiting tool. According to Klarman, it’s irrational to sell a holding when its price falls. If an investor bought the holding in the first place, based on proper value analysis, a new decline in price only means that the bargain is bigger and averaging down will increase one’s return. Letting the market decide when you should sell is totally crazy according to Klarman.
Proper portfolio management can really take advantage of the market’s irrational behavior by allowing us to buy when things are cheap and sell when they’re fairly valued.
Following the market allows us to properly diversify in order to lower our risks and increase our returns. For example, gold stocks in general are relatively cheap at the moment which allowed me to find a few interesting bargains that properly diversify my portfolio against monetary risks.
I somehow feel there will be much more monetary easing coming from the developed world as there is no political will to deleverage now that things are going well. Later, when things eventually turn for the worse, it will be too late to deleverage and currency values might suffer. Gold is an excellent hedge, especially if it comes in the form of an extremely cheap, low cost growth gold miner. Owning such a gold investment with only a fraction of your portfolio allows you to protect your portfolio from inflation and any kind of economic turmoil that might hit the financial system.
If gold goes to $2,500, I wouldn’t be surprised to see many gold stocks go up ten or even twenty-fold. Therefore, if you have 4% of your portfolio in gold miners and there is trouble, the 4% can easily become 80% of your portfolio. Investing 4% to protect 80% is a good risk reward investment to me, no matter what happens to the price of gold. If nothing happens and gold goes to $400 per ounce, you’ll lose 4% of your portfolio while the other 96% would probably double. So, as Klarman would probably say, it’s always about risk and return, and the larger the margin of safety, the better.