In our last post, we discussed our approach to long-term and fixed asset valuation. We concluded that, given our inability to actually value any given asset or class of assets, the best that we could do is fix a point at which we feel that we are more likely to be right than wrong about a stock’s value but would also have enough opportunities to invest. We argued that magic point for us in relation to property, plant and equipment is 50%, based on nothing more more than our limited experience. We acknowledge that this method will cause us to make many mistakes, so in this post we set out our method for protecting ourselves from those mistakes.
We try to protect ourselves from our mistakes in three ways:
- We try to buy at a substantial (i.e. more than 1/3) discount to our estimate of the written down value. Sometimes our valuation will be so wrong that the discount will be an illusion, and the real value will be well south of our estimate (maybe somewhere near Antarctica). In those instances, if the liquidation becomes a reality, we will lose money. In other instances, the real value will be higher than our estimate, and we will make money. Our hope is that the latter occurs more frequently than the former, but we are certain that the former will occur regularly.
- We try to buy a portfolio of these securities and we don’t concentrate too much of the portfolio in any one security. The more certain we are about a security, the larger the portion of the portfolio it will command. This means that net cash stocks that have ceased trading and are in liquidation or paying a special dividend take up a larger proportion of our portfolio than cash-burning industrials in liquidity crises with value wholly concentrated in property, plant and equipment (that said, at a big enough discount, they might take up a lot of the portfolio). This means that if any one stock, or even a handful of stocks, go to zero or thereabouts, they don’t destroy our entire stake and we can live to invest another day.
- We try to follow investors much smarter than we are. From our perspective, there’s no shame in riding on someone else’s coat-tails, especially when those coat-tails are on the back of someone smarter, better resourced and more experienced. This is one of the main reasons we only invest when we can see a Schedule 13D notice filed with the SEC (the other reason is that the 13D filing is the precursor to the catalytic event that removes the discount). Often, the 13D notice will set out the investor’s rationale for the investment, which may include their view on the stock’s valuation. While we always do our own research, we are comforted when we see other value-oriented investors in the stock, and we hope that experienced, professional, value investors are right more often than they are wrong (even though we know that they will also make mistakes).
The first method above attempts to limit the effect of an error in valuation on any given investment. We hope that if we’re wrong about the value, it’s only by a matter of degree, and we can salvage some value from the investment. The second limits the damage that a total, or near total, destruction of value in any one investment does to the portolio as a whole. The third is a check on our thought process. If we’re right about a situation, we’d expect to see investors smarter than we are already in the stock. If they’re not there, we’d have to look deep into the abyss before jumping in. We haven’t had to do that yet.
We hope that this better explains our approach to investment. Once again, we’re always keen to hear other points of view, or to have someone point out the obvious holes in the argument.