The Value of Patience

Price-value gap

Theoretically, with higher trading volumes, the price-value gap should narrowdue to better price discovery.   Yet, in reality, this is not the case. 

The increase in trading activity actually widen the price-value gap; often increasing the noise in the system and leading to spikes in volatility that we see often in the stock market. 

An explanation, which is not surprising, is the majority of market participants are speculators and not investors.  

Rather than narrowing the price-value gap through better price discovery, theexact opposite is the result.


What can you do as an investor?

In this world, an investor who is hostage to short-term performance pressures will feel nothing but discontent. 

The only requirement for successful play is the willingness to adopt a different set of rules.  

Of these, none is more important than the value of patience.


Let's learn from Buffett:  Having a patient attitude to investing

Time and patience, two sides of the same coin - that is the essence of Buffett. 

His success lies in the patient attitude he quietly maintains toward both Berkshire's wholly owned business es and the common stocks held in the portfolio. 

In this high-paced world of constant activity, Buffett purposefully operates at a slower speed.



Learning points

A detached observer might think this sloth-like attitude means forgoing easy profits, but those who have come to appreciate the process areaccumulating mountains of wealth.  

The speculator has no patience. 

The investors lives for it. 

The best thing about time is its length.

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Four Steps to Prepare for a Crash

But for the sake of argument, let’s pretend that Time’s cover is wildly bullish and did send a legitimate bear signal to the world. Or maybe tapering will sink stocks. 

What would be the proper course of action for investors in a bear market? 


1. Understand your time horizon 

If you invested 10 years ago for an event this year, you might seriously consider selling your stocks and converting them to cash — but that’s regardless of where you think the market is going. If you need the money in the short term, it doesn’t belong in the market. If you have longer than a few years to invest, don’t worry about a crash as long as you… 

2. Make sure your stops are in place 

The Oxford Club recommends a 25% trailing stop loss. The stops protect gains as stocks rise and ensure that no single position results in a devastating loss. Since stocks are up so much over the past four years, even if you do get stopped out, you should get out with a profit. This strategy also ensures that you have plenty of cash to get back into the market at lower prices. During the financial crisis, Oxford Club Members were stopped out of positions in 2008 and took profits on many stocks that had risen during the previous bull. That freed up capital to get back in during the lows of 2008 and 2009, resulting in some huge winners, including Discovery Communications (Nasdaq: DISCA), up 255%, and Diageo (NYSE: DEO), up 171%. 

3. Review your portfolio 

If you haven’t done so in a while, take a look at the stocks in your portfolio. Make sure the companies are still operating at a high level. If you own Perpetual Dividend Raisers — stocks that raise their dividend every year — examine when the company last raised its dividend. If the company is continuing its streak of annual dividend raises, generally speaking, you should be fine for the long term. 

4. Be ready to buy when things are bleak 

It takes a lot of guts to buy stocks when it feels like the market is falling apart, but that’s how the biggest gains are made. Whether you’ve raised capital by selling stocks whose stops were hit, or you have money set aside, buy stocks after a market slide. You might not catch the bottom, but since stocks go up over the long haul, getting them at a discount will add significantly to your returns. Regardless of the predictability of the magazine cover theory or any other signal, long-term investors should not get caught up in the day-to-day market noise. You will make money as long as you don’t panic in the face of a sell-off. 

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Nine lessons to learn from Seth Klarman

SO WHAT DO WE KNOW ABOUT HOW KLARMAN INVESTS? HERE ARE SOME INSIGHTS INTO HIS APPROACH.

What’s your advantage over others? 

The investment markets are crowded. Thousands of professional investors spend their days trying to find the next big thing, but they can’t all win. In order to get ahead you need to do something or know something that others don’t. This is not easy. Are you really smarter than the crowd?

Buy what others are selling

Going against the crowd can be profitable. People often sell assets due to temporary, short-term factors. This offers opportunities for investors who can take a longer view. Examples of such situations are litigation, fraud, financial distress and ejection from an index.

Go where others don’t

Following on from the above two points, it makes logical sense that you are unlikely to make a lot of money buying FTSE 100 shares, as professional investors follow them too closely. Look at lots of different asset classes. For example:

• Opportunities often exist in ‘spin offs’ – smaller businesses sold by bigger companies. Professional investors often sell holdings in these companies because they are too small and this temporarily depresses their value, spelling a buying opportunity.

• Research bonds in bankrupt companies: often these bonds sell for a fraction of what they are worth. If the company is turned around, investors can make massive gains. There are often similar opportunities in distressed property.

• Don’t confine yourself to domestic markets. Foreign markets are often less crowded and can be subject to levels of political and regulatory uncertainty that present opportunities. In the preface to the sixth edition of Benjamin Graham and David Dodd’s book, Security Analysis’, Klarman uses the example of South Korea in the early 2000s where investor pessimism saw multinational companies selling for as low as one or two times their annual cash flow. Smart investors made a killing buying these stocks.

Focus on risk before you start thinking about returns 

Research shows the pain of losing 50% of your money far outweighs the pleasure to be had from making a 50% return. To be successful as an investor you must focus your research on the risks of a company’s business model and its industry. Remember that the first rule of investment is not to lose money. Also remember – and this is particularly pertinent to technology companies – that today’s good business may not be tomorrow’s winner (see my colleague Tim Bennett’s points on the importance of economic moats for more on this).

You are buying a stake in a business, not a piece of paper 

Investment success comes from buying the cash flows of businesses for less than they are worth. These cash flows come from the real world, not punting numbers on a computer screen. So focus on free cash flow rather than profits. And look at balance sheets to see risks like too much debt or big pension fund liabilities.

Know when to sell

Value investors start selling when assets are 10-20% below what they think they are worth. Owning fully valued assets is a form of speculation – you are betting on someone paying more than they are worth, not on the market recognising the true value of the assets.

Don’t invest with borrowed money 

The ability to sleep well at night is more important than a few more percentage gains.

Don’t rely on the market to provide your investment returns 

If bond coupons or stock dividends (paid out by companies) can provide a large chunk of your returns, you are less reliant on fickle and volatile markets for capital gains. Buying bonds below their redemption value is another good strategy.

Don’t be afraid to do nothing

Always hold cash when cheap assets are scarce. Be prepared to wait.

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Confessions of a bargain hunter, Seth Klarman

In the offices of an unmarked high-rise building in Boston sits Seth Klarman, surrounded by stacks of papers and books, which, by his own admission, are at risk of toppling over and crushing him at any instant.

Klarman is the founder and president of the phenomenally successful Baupost Group, a $29 billion ”deep value” hedge fund. It has produced 19 per cent annual returns, and every $10,000 given to Klarman at inception in 1982 is worth about $1.85 million today – and this was achieved while carrying extremely high levels of cash (more than 50 per cent at times) and using minimal leverage.

So how did he do it?

Know your seller

The financial markets are fiercely competitive, with millions of investors, traders and speculators around the world trying to outwit one another. Klarman concluded that since prices are set by the forces of supply and demand, rather than buy something and wait for someone to demand it at a higher price, why not wait for an irrational supplier to sell it to you for any price?Hence, Klarman looks for assets that people are being forced to sell or avoid, often as a result of fear or institutional constraints.

You can apply this principle by looking at heavily sold or avoided opportunities closer to home.

For example, stocks at the bottom of the S&P/ASX 200 are kicked out and replaced on a regular basis and, since index funds can hold stocks only over a certain size, newly removed stocks from the S&P/ASX 200 are sometimes driven down in price because of the selling pressure from such funds.

To make matters better, owing to regulation many super funds often cannot invest in smaller companies and such stocks are rarely followed by analysts. Servcorp resides on Intelligent Investor’s buy list and falls into this category.

Some institutions are also forced to ignore debt instruments unless they achieve a certain credit rating, even though they might offer an attractive risk-reward profile. You can take advantage of this by investing in income securities in a downturn, when large price falls create great opportunities such as those in 2009, for example, the Goodman PLUS, Dexus RENTS and Southern Cross SKIES hybrid securities.

Tax-loss selling (in Australia, this tends to occur in June, at the end of the financial year) can cause irrational mispricing in already beaten-down stocks. Cheap blue chips that could be this group next week include Computershare, QBE Insurance and Macquarie Group.

Competitive advantage

The difference between great investors and mediocre ones is only a few percentage points in terms of judging things correctly. Klarman realised he would have to bring something different to the game to win: a ”competitive advantage”.

”I will buy what other people are selling,” Klarman says. ”What is out of favour, what is loathed and despised, where there is financial distress, litigation – basically, where there is trouble.”

An inexperienced individual will have little success using such a tactic. After all, how many of us have four years to spend analysing Enron’s accounts? Instead, look for inefficiencies you can exploit.

Most market participants have a narrow, short-term view and are driven by fear and greed. So your edge is having a longer-term perspective and controlling your emotions. These two advantages will help you pile on the performance points over the professionals. Both have been invaluable to Klarman.

Cash is a weapon

Holding cash is perhaps Klarman’s most famed characteristic.

However, contrary to what you might expect, Klarman holds cash so it can be used in a concentrated manner when the right opportunity arises. This is because while value investing outperforms in the long run, Klarman quips that ”you have to be around for the long run … [you have to make sure] you don’t get out and you are a buyer”.

Despite the complexity of some of his investments, Klarman’s underlying approach is not complicated, although that is far from saying it is easy.

He says Baupost has outperformed ”by always buying at a significant discount to underlying business value, byreplacing current holdings as better bargains come along, by selling when the market value comes to reflect its underlying value, and by holding cash … until other attractive investments become available”.

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