There is often this inherent conflict in a value investor‘s mind that continues to play for almost every investment he makes. If you have been investing for a while, you will read what I am writing and nod along. You know what I am speaking of.
Best Value Investors Have 2 Qualities in Balance
Quality 1: Arrogance
Yes, I said Arrogance. It is a sign of arrogance to take a position against the market.
As a value investor you are saying “Mr. Market, I see what you have to offer. This is how I counter. Play with me or I take my ball and go home”.
Of course, this arrogance is mostly well founded. As a good value investor, you have spent hours and days poring through the books, tracing the sources and uses of the cash, figuring out the corporate strategy, and generally getting into the head of the management to understand how they run the business. You have probably spoken with the customers, competitors and suppliers. You have run the numbers, listened to the conference calls and gone through the management discussion in the financial reports.
At the end of it all, when you speak, you know what you are talking about, and you say “I am right, you are all wrong. This is why”
In fact, you risk your money confidently to back up your findings, against the “wisdom” of the crowds.
Quality 2: Humbleness
Like Yin and Yang. the arrogance needs to be balanced by the appropriate level of humbleness. Value investors are often wrong. Investing is not an exact science, and it involves a lot of assumptions and resolving ambiguous scenarios to come to a firm decision to buy or sell or do nothing (“Doing nothing” is a decision, probably the most important decision you will make in investing. Also the most frequent).
As a value investor you understand that there are things that you are not able to crystallize and boil down to mere numbers. You calculate the intrinsic value of a security, but there are a lot of assumptions that can change this value if they turn out differently. The elegant solution to account for unknowns and unknowables is to discount the intrinsic value calculation by a certain amount (30% typically, but it will depend on how confident you feel about your analysis, sometimes you may want more discounting). This is the so called “Margin of Safety“.
Requiring a margin of safety is prudent, but also an admission that you are not perfect. Every value investment analysis starts with some level of humbleness baked into it. However, this is not enough. As an investor you need to expect that there will be times when some investments go wrong. Some times very wrong.
You need to be able to understand when you are wrong and do it in time to limit your losses (or find the right time to purchase)
Valeant and the Tale of 2 Valiant Value Investors
It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.
– A Tale of Two Cities, Charles Dickens
Tale ONE: Bill Ackman has been the poster child of the hedge fund industry. In recent times it does seem like whatever he touches turns to coal (Actually, this year coal may be a good thing, better than his other investments!). Atleast his misadventures with Valeant seem to be over with his formal apology to his investors over the huge mistake.
About $4 Billion in loss later, Ackman continues to be not fired and enjoys the confidence of the board. This is possibly a record of the largest loss ever on a single investment without getting fired. As RCM Alternatives puts it eloquently, let this be a lesson to all investors to not blindly copy the investments of a billionaire. According to them, Ackman was married to his trade. There is a difference in being disciplined and resilient from being just hard headed unwilling to accept own mistakes.
Over the years I have enjoyed the skirmishes between Ackman and Icahn. I have tremendous respect for Icahn as an investor and arbiter of value, not so much for Ackman.
However, and I am letting my biases show, even the man who wrote the book on valuations is not immune nor infallible at times. But can they stay rational?
Tale TWO: Aswath Damodaran writes about his investment in Valeant. Valeant has been a crowded trade for a long time with so many wannabe value investors following in Ackman’s footsteps. Professor Damodaran stayed away from Valeant for a very long time. But as they say, any asset is a buy at the right price. Sometime in 2016, the good professor considered the stock price cheap enough to wade in. Later he doubled down as the stock became even cheaper. It has been a disaster in his portfolio but not so much as it was for Mr Ackman.
As Ackman exited his position in the stock, it was right time to review if the valuation of the company justified the current stock price. In the latest analysis, Professor finds that the stock is currently priced just below the intrinsic value, and therefore it does not make sense to exit.
My Take on All This
I have no doubt that the valuation models that both the investors used are correct. I also fully believe that Mr Ackman was right, by his models, to exit the position now. At the same time, Professor Damodaran is right, by his models, to stay with the stock now.
It is the same company and the same business they are both analyzing. They are both accomplished valuators and investors. They are both fully aware of the history of the company, its flawed business model, and the risks involved. So why different conclusions?
One of them is right at this point in time. We don’t know who. However it is safe to say that the scale of the prior losses and the pressure from his investors and the enormous public scrutiny might have had something to do with Ackman’s decision to exit and issue an apology, whereas these considerations do not have the same gravity for the professor.
You want the investor you follow to be objective and not base his decisions about the future on the past events that may no longer be relevant. The fallibility in a value investor lies in sometime not recognizing the situation correctly and not being objective enough and made decisions that are driven from depths of despair and fear. A good value investor needs to have a “selective amnesia” about the past – after you have taken your learnings from the past, the past should be forgotten.
Why Do You Invest in the First Place?
This is a very fair question every investor needs to ask of themselves every so often.
For some, investing can be a challenge in conducting proper valuation analysis. To see where investment theory and practice intersect, and how theory and practice can inform each other better over time.
For some others, investing can be all about imposing yourself on a situation and squeezing profits out of it.
For most of the rest of us value investors, we are just looking to find mispriced opportunities and capitalize on them before others find out about them.
The way you act in each of these situations will be different because your goals are different.
I did not buy Valeant and have no interest in buying Valeant now for the simple reason that the complexity of the business and the unknown risks are just not worth it. If you believe that you have additional things to bring to the table, like large amount of funds, ability to change the management at will, or a perceived edge in your valuation models, these investments can become worthwhile to you. In a way, the investments you choose should depend on your understanding of yourself as an investor and person.
You need to find your own edge.
NOTE: The Amazon link to the valuations book is an affiliate link. It generates a commission to VSG but costs the same to you. Thank you if you purchase. All books I recommend are like my stocks – only the ones that I invest in myself