V KatsenelsonQ. What provision does the value investor make for an error in his estimation of the "true" value?

A. Investing is not a precise science, a fair value is an estimate. That estimate is as good as the assumptions that went into it. I detest the precision of many sell side analysts when they estimate the value of the company (i.e. we believe this company is worth $10.75 thus at $10.10 it is 6% undervalued). I suggest to tamper with assumptions to arrive to ranges of estimate (i.e. change discount rate, sales growth, profit margins etc., tinker with them to figure out the impact they have on the fair value. Also playing with these variables will help you to understand which ones have the most impact on the value of the firm and thus you can spend your time focusing on things that really matter).

In my analysis the required margin of safety is a function of two variables: company's quality (the higher the quality the less margin of safety I need); and fundamental return (earnings growth and dividends), the lower the fundamental return the higher margin of safety I'll require as I need to be compensated for the stock turning into dead money. In other words when you own a company that doesn't grow earnings or pay a dividends, a time is not on your side, thus you want to make sure that you are compensated for that by a larger discount to fair value.

Q. What of Keynes's warning about the tenacity of the market's irrationality outlasting one's funds or investment horizon. How do you deal with that?
A. Great question!

The point I made above answers this question somewhat, but I'll repeat. If I own companies that pay dividends and grow earnings I'm compensated for the wait. Dividends provide a real time payments, where earnings growth makes companies more and more valuable, compressing the P/E under the stock.

This is a reason why I don't use leverage. Leverage compresses the time of your bet. Even if you are right on undervaluation, leverage may kick you out of the position before your proven right. To some degree this is what happened to LTCM, they were right on the arbitrage but because of the high leverage they did not survive to see themselves being proven right.

Q. Also, at what point does the value investor exit on the upside, assuming that the market "wises up" to the "true" value of the stock and starts bidding it up? When the price reaches value, or when it overshoots it by some predetermined amount, or what?

I suggest figuring out the sell price or sell P/E (I prefer P/E) at the time of purchase. This way you have not developed the psychological attachment to the company. I discuss selling in my book in depth (Active Value Investing: Making Money in Range-Bound Markets). The sell price will be close to the fair value point.

Q. Finally, can't the stock price itself affect "the fundamentals" in a Sorosian fashion (e.g., cost of capital, certain loan provision triggers, ability to make acquisitions, attractiveness as an employer, etc)?

A. I try not to own companies that rely heavily on external financing or their P/E staying high so they can make "accretive" acquisitions. This point you touched upon is so true with banks in today's environment; they have to issue stock because their capital is destroyed, but their stock is down. But let me give you the opposite side of this: I own UNH , WLP, NOK and Microsoft , these companies have couple things in common, they have incredible balance sheets (NOK and MSFT have no net debt and billions of cash), lower stock prices will provide these companies an opportunity to buy their stock on the cheap.

Q. The bedrock premises of value investing have always left me slightly puzzled, as if I'm missing something.

A. I guess the idea behind value investing is to find companies that market misprices (often for psychological reasons) and sell them when market recognizes the error.





Speak your mind

5 Comments so far

  1. Manuel Bravochico on August 20, 2008 7:11 pm

    Nice interview Vitaly.

    Here’s another one.
    It seems that most large investors seem to be value guys as opposed to momentum ones. Is that out of necessity for liquidity or indoctrination of business school?

    When I talk with my colleagues who work at mega funds, they seem to judge momentum investors as gamblers but view value investing as “a real business”.

  2. Joe Posillico on August 20, 2008 7:11 pm

    Bedrock premises of value investing -

    1. Anti-Efficient Markets - (a) Market price is more volatile than intrinsic value of the firm, providing an opportunity to buy or sell when the market overreacts. (b) Risk is the permanent loss of capital. It is not beta. We can manage risk by knowing our circle of competence, and by buying at a deeper discount (margin of safety). If price falls though it is crucial to understand if the underlying fundamentals of the company have changed.
    2. Some markets are more efficent than others. So look for neglected areas where you can have an edge.
    3. Valuation - Not all information is equally forecastable. Thus traditional DCF and multiples valuation is problematic because it combines reliable info with unreliable info. Financial analysis and strategic analysis are inseparable. Not all growth has value, and most investors overpay for growth or the hope of growth.

    * This is all much easier said than done. For further reading see Ben Graham, Bruce Greenwald, Seth Klarman, Joel Greenblatt, Warren Buffet letters to Berkshire Hathaway shareholders *

  3. George Parkanyi on August 20, 2008 9:56 pm

    I trade a unique, self-designed system where I re-allocate between individual securities organized into small groups of fixed names (a defensive partitioning money-management technique), using a variety of non-correlation criteria to maximize price divergences. The re-allocation algorithm is very simple, and I have been able to quantify/project the expected compound rate of return as a function of the average volatility band of the component stocks.

    Because this technique is a form of averaging down, I also don’t use leverage (other than intrinsic leverage offered by some 2x leveraged ETFs), and have to be very selective to make sure my fixed names don’t get un-fixed via de-listing.

    I have a pretty good value filter that I use for my single-stock selection, which I complement with a cash analysis. I REALLY like companies whose share price is covered by 20% or more cash. In fact I’ve stumbled into a number of take-overs in the last couple of years using this filter (KOS Pharmaceuticals, Florida Rock, and Axcan Pharmaceuticals. Acquirers like to see strong cash flow and large cash balances because they help pay for the acquisition.)

    I just did an analysis last night and here are a few examples:

    Formfactor (FORM) 59% of stock price is cash & equivalents
    Omnivision (OVTI) 49%
    American Oriential BioEngineering (AOB) 23.3%
    Nvidia (NVDA) 19%
    Tessera Technologies (TSRA) 20%

    TSRA, AOB, and FORM’s cash also more than 4x covers all liabilities.

    FORM and OVTI are a little doggy with fairly low ROEs at 10% and 12% respectively, but the cash piles are huge.

    If companies have shown average 5-year ROE over 15% then I’ll settle for less cash.

    QLogic (QLGC) is 15% cash, but has a better 16% growth rate. Nvidia (NVDA) is attractive here at 19% cash and 20% growth - especially for a well-known brand.

    Today I added AOB to the portfolio, both for the type of exposure I wanted (more China and healthcare) but also because it passed the value/cash screen. It’s ROE is 14%. (Naturally it will immediately go down, since I’m ALWAYS early.)

    One other stock that recently made my value screen is Eli Lilly. With its 26% ROE, adequate cash and liabilities coverage and 4% yield, LLY seems like a great buy. So is the mentioned Nokia (NOK). Not quite on the screen, but with a 48% ROE, 3% yield, great brand, and similar balance sheet profile to LLY, also a looker.

    Because I’m re-allocating on a relative price basis I don’t mind if a stock gets stuck in a trading range for a long time, whether profitable or not relative to its initial purchase. The fluctuation is what makes the compounding contribution to the portfolio as it interacts with the stocks around it. What I can’t have is a stock go to 0 or near-0. That’s why value screens supported by cash buffers are important for this method.


    As an additional public service to all you faders out there - I own FORM, NVDA, AOB, and QLGC. Really thinking hard about LLY and NOK. :)

  4. Benny G. on August 23, 2008 5:14 pm

    If Vitaly is going to be such a public figure, why can’t he make public some kind of fair representation of what his track record has been?

  5. M J Adams on September 6, 2008 10:06 am

    Like George Parkanyi (Aug 20th) I also trade a self-designed system. I go short when price drops below the 200-day MA. I did very well out of FORM and NVDA without a fraction of the trouble he went to.


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