One of my favorite Benjamin Graham quotes:
Benjamin Graham Testimony to the Committee on Banking and Commerce Sen. William Fulbright, Chairman (11 March 1955)Chairman: … One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realise it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens? (Rephrasing) What causes a cheap stock to find its value?
Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know from experience that eventually the market catches up with value.
This is one of the rationales for looking at distressed debt. If you are fortunate enough to correctly identify a miss-priced equity and have accurately determined its intrinsic value, your IRR is determined by the mystery timing of “markets catching up with value”. With a distressed debt investment the timing pre-determined by maturity.
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Great point.
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or the market is being efficient and telling you that payment is not coming at maturity and will be resolved at a lower than par level.
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Graham did however warn of the danger of tardy adjustment of price-value:
“Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants. 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. The analyst must seek to guard himself against this danger as best he can: in part, by dealing with those situations preferably which are not subject to sudden change; in part, by favoring securities in which the popular interest is keen enough to promise a fairly swift response to value
elements which he is the first to recognize; in part, by tempering his activities
to the general financial situation—laying more emphasis on the discovery
of undervalued securities when business and market conditions are on a fairly even keel, and proceeding with greater caution in times of abnormal stress and uncertainty.”
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Great quote. Thank you.
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Adequate diversification (~15-20 securities or cash) provides some defense against the aforementioned risk.
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Flip side of course is “The market can stay irrational longer than you can stay solvent.”
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Indeed. One of the reasons to eschew debt or securities with embedded debt.
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