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.


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