Being too far ahead of your time is indistinguishable from being wrong.
-Howard Marks (Trades, Portfolio)
Undervaluations caused by neglect or prejudice may persist for an inconveniently long time. The particular danger to the analyst is that, because of such delay, new determining factors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably, and the facts and reasoning on which his decision was based may no longer be applicable.
-Ben Graham and Dave Dodd
In one of my previous articles, I posted my notes on the Q&A session from Howard Marks (Trades, Portfolio)’ talk on Google (GOOG, Financial)(GOOGL, Financial) campus. Since then, I have been pondering the following question and answer:
Question: You talk about the gap between value and price, but the other dimension is time. How do you estimate the amount of time it takes for that value gap to close?
Answer: You never can. This is another great question. On occasion there will be catalysts such as the pending maturity of the bond. Another catalyst today is the activist investors. But not that many companies will get activism to unlock the value. There are more catalysts in the fixed income world than in the equity world.
In other article I wrote in September last year, I included a chart from Chapter One of Security Analysis; for the purpose of this discussion, let’s review this great chart again.
Let’s also revisit the conclusion observed by Graham: “It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”
There seems to be a conundrum faced by all value investors – value investors should be bottom-up fundamental analysts but doing so exposes us to the risk of being too early if we ignore the other market factors. This is something I have personally struggled with and will very likely continue to struggle with in my investment journey.
One comforting fact is that as long as we are right about the fundamentals of the business and have a long-term investment horizon, the chances of being far ahead of the time diminish dramatically. However, most of us will make investment decisions that are perhaps 2-5 years horizon. In these situations we should probably pay attention to the market factors and even the speculative factors that influence the market price of the security.
This means maybe we should open our mind and explore how others in the equity market think and behave. After all, value investors are probably only 5% of all the market participants and only 1% are genuine value investors, according to legendary value investor Jean-Marie Eveillard.
I don’t know about you, but I was shocked to find out that more than 80% of the trading was done by high frequency trading computer algorithms with complete disregard of the fundamentals of the business. Maybe we should have basic knowledge of how it works. This may have partially explained the sell-off of media companies even though some of them have shown strong fundamental growth.
Then we should also try to understand the sell-side reports – these reports are something we should game against. I’ve read many sell-side reports. There’s no doubt the quality difference is huge, but I’ve found the knowledge of the sell-side analysts in major brokerage firms is satisfactory. They often do a great job nailing down the fundamentals of the business but fail spectacularly in the valuation part. Regardless, these reports are read by other market participants who are portfolio decision makers, and very few of them are value driven. So we should at least be aware of their argument and come up with deeper or better thinking.
Howard Marks (Trades, Portfolio) also brought up a great point – catalysts. Sometimes there are no obvious catalysts except for the great compounding power of business. This is the case with most very predictable companies such as Nestle (NESN, Financial) or PepsiCo (PEP, Financial), or widely-known businesses such as Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and Markel (MKL) running by best capital allocators. But more often than not, you should think about the potential catalysts that will change the market perception or unlock the value of the business. For instance, when Mohnish Pabrai (Trades, Portfolio) invested in Horsehead Holdings (ZINC, Financial), one of the catalysts was the upcoming of the completion of much more efficient manufacturing plant, which will lower the cost of production dramatically. Corporate actions such as management change, spin-offs, reorganization and recapitalization are also good examples of catalysts. But you have to be aware that the market price will be likely to quickly incorporate the catalysts when the news is out.
To cope with this issue, I have added an item on the investment checklist after both observing the lessons from other investors and being humbled so many times personally – do I understand the market factors that affect the market price of the security? I think Todd Comb’s investment in CB&I (CBI, Financial) and Viacom (VIAB, Financial), Chuck Akre (Trades, Portfolio)’s investment in Colfax (CFX, Financial) are example worth studying.
