Chas Craig, BridgeTower Media Newswires
“History doesn’t repeat itself, but it often rhymes.”
–Mark Twain
Seth Klarman’s “Margin of Safety” (1991) is a favorite among value investors. Below is an excerpt from the book’s introduction.
“If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public’s favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.
“The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.”
A value approach has indeed been a handicap recently as the stock market has been steadily increasing arguably on the path from “fully valued on its way to being overvalued.” For example, over the past five years the Russell 3000 Growth Index has provided investors with an 11.8% annualized return, while the Russell 3000 Value Index has handed its holders just 6.6% per annum.
It would be a great disappointment for those following a well-conceived value strategy if they didn’t do noticeably “less bad” than their benchmarks in the event stocks decline considerably (call it +20%) and stay down for a little while. Herein lies the frustration of the value investor ... in up markets they earn less, in down markets, well, they’re still down. The compensation expected to accrue to skillful value investors for enduring this scenario is a higher long-term compounding rate with less volatility in the return series.
As alluded to, a value approach should work best when markets go down and stay down for a little while to allow time to find attractive investment opportunities. The last time stock markets came under pressure for any considerable time was late 2015 to early 2016. Since then, market sell-offs have come, but V-shaped recoveries have provided precious little time to put capital to work.
Below is another excerpt from Chapter 1 of the previously referenced book discussing mistakes frequently made by investors which pertains to the previous paragraph.
“Another type of formula used by many investors involves projecting their most recent personal experiences into the future. As a result, many investors have entered the 1990s having “learned” a number of wrong and potentially dangerous lessons from the ebullient 1980s market performance; some have come to regard the 1987 stock market crash as nothing more than an aberration and nothing less than a great buying opportunity.
The quick recovery after the October 1989 stock market shakeout and the 1990 junk-bond market collapse provide reinforcement of this shortsighted lesson. Many investors, like Pavlov’s dog, will foolishly look to the next market selloff, regardless of its proximate cause, as another buying ‘opportunity’.”
The parallels to the market environment Klarman described almost 30 years ago to today are striking. Investors have recently been conditioned to view any market selloff as a great buying opportunity. History teaches that once a point of view becomes widely embraced on Wall Street, considering the opposite is advisable.
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Chas Craig is president of Meliora Capital in Tulsa (www. melcapital.com).
