Margin of Safety
I admire Seth Klarman for his investment discipline and his realistic view of business models and securities analysis. As I have written before, his book “Margin of Safety-Risk Adverse Strategies for the Thoughtful Investor” is out of print but can be purchased online for slightly more than $2000. I have read it and gleaned some useful observations, most important of which is Mr. Klarman’s distinction between speculators and investors: “Just as financial market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations…But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.”His small cohort of value investors includes Howard Marx, Mitch Julius, Glenn Greenberg, Liu Lu, Jeremy Grantham and Warren Buffet. With the exception of Warren Buffet who has rock star status and can convince people like Jimmy Haslam to sell Pilot Flying J to him, their ability to put money to work in this investment environment is dwindling as almost all markets make new highs.
Value Investing Is Intellectual Humility
Their investment premise, however, is so right and fundamental that we all should pause and reflect on what is really happening in the Wall Street casino. At its core value investing is intellectual humility. It recognizes the need for a margin of safety in all investments because the future cannot be known. Once the intrinsic value of a business is determined, there has to be a further discount to account for uncertainty. Given the proliferation of collective products like ETFs and mutual funds, the retail investor wrongly believes that he mitigating risk because he is buying a low fee, low volatility product. Risk and volatility are easy to confuse but true value investors will tell you they are unrelated. Because the ETF product is meant to mimic an index or a sector, the important investment strategy is to compile a portfolio that accurately tracks collective performance. In market capitalization ETFs, winners are over weighted and losers are underweighted even to the point where 4 or 5 stocks like Amazon. Facebook, Google and Apple are providing all the juice.For example, just 59 stocks account for 50% of the market weighted value of SPX which is the S&P500 ETF.
Concentrate On The Losers
The value investor would be more interested in the losers. General Electric (NYSE,GE), for example, should be a target for value investing inquiry. It has lost 35% of its market value in the last 12 months and has become less important and least represented of all the Dow stocks making it an afterthought to ETFs. It has a 4.5% dividend yield but no free cash flow. An activist investor has been elected to the Board and a new CEO, John Flannery, who ran GE’s healthcare operations is ready to unveil a plan of reorganization on November 13. Speculation about a big dividend cut and a sale of assets is pervasive. Since GE has no free cash flow and has limited debt capacity, the dividend probably should go to zero. Instead it is more likely that the new management will liquidate assets to pay a reduced dividend. This is just a slow liquidation plan reminiscent of Sears. Reducing overhead expenses for shared services as you shed operations is always a lagging problem and GE has plenty of shared services.
If the new CEO has any guts he will eliminate the dividend at which point the stock will likely fall by another 30% and a value investor like Seth Klarman may be interested. The break up value of GE net of debt and unfunded pension should exceed $15 per share. The likelihood of a break up is enhanced because the institutional sellers who are following analyst recommendations will sell and will be replaced by more activists who can wage a proxy contest to force a full break up.
Pit Boss Advice Is Suspect
The intellectual conceit about GE is evident, however, in the number of reputable analysts who have rated it a sell. Of the 17 analysts covering GE Yahoo Finance reports 5 are strong buy, 4 are buy, 6 are hold and 2 are underperform. Only Deutche Bank issued a sell recommendation earlier this year. Apparently none of the analysts, having ridden it down ,think it is risky enough to sell. This is like a casino suggesting a gambler on a losing streak substitute keno for craps; they stay in the game but with worse odds. Seth Klarman would not find any margin of safety in rigorous and well intentioned securities analysis. He would look for the free cash flow and, finding none, would move on to the next opportunity.