Below is an excerpt from our first investor letter.
ıt outlınes our approach, and how we thınk about value ınvestıng, effıcıent market hypothesıs and margın of safety
thıs letter sent out to investors in july 2014
In our first investor letter, it is important to take a step back and look at the core thinking behind Stylus Capital’s investment approach before going into the details of our individual investments. Our investment strategy relies upon the same two core concepts often quoted in a value investing context: “Margin of Safety” and “Market Inefficiency”.
“Margin of safety” is a widely used term coined by Ben Graham. It refers to buying pieces of businesses (stocks) at such discounted prices that, given the company’s expected performance trajectory 2-3 years into the future, it is virtually impossible to suffer any “losses on principal” (negative returns) over the period. The same discount must also make it very likely to obtain strong returns on investment.
Of course, this exercise would require making a set of assumptions regarding the company’s future. Therefore value investors would choose to stay away from any company whose future is hard to predict by nature. They would instead focus on companies for which a reasonable set of assumptions is possible to make. Such companies are the ones with simple, predictable businesses and “wide moats around them”, meaning their financial performance have a very low likelihood of worsening due to a new competitor or a changing market landscape.
Once a reasonable set of assumptions are made, the investor could then look for a price that has a wide enough “margin of safety” such that he or she would have to be substantially wrong before the investment can generate negative returns.
The second concept, “Market Inefficiency”, requires further discussion since it is arguably even more central to the value investing philosophy than “Margin of Safety”. After all, if the proponents of the “Efficient Markets Hypothesis” are correct and the market prices always reflect the fair value of a business (i.e. if markets are always efficient), then there can be no margin of safety to speak of. Markets would have already made the correct set of assumptions regarding future of the company, and would reflect a fair price based on this correct assumption set. If a company appeared to be deeply discounted based on an investor’s assumption set, then investor’s assumptions would have to be wrong.
This is clearly a dramatic way to think about market prices, yet surprisingly it is very much at the core of most academic work on financial markets.
The value investors’ view on market prices is a bit different: They believe markets reflect a reasonable price for equities most of the time. They believe it is a “voting mechanism” through which a very large number of people deploy enormous amounts of capital to establish a fair price for each security. However this “voting mechanism” fails often enough (even for largest companies) that an investor looking in the right places can identify outstanding businesses sold dramatically below their true value.
The question is then, how could this “voting mechanism” possibly fail often? After all, there are many bright individuals backed with tremendous amounts of capital constantly seeking profits in financial markets.
Joel Greenblatt, a very successful former fund manager who is currently teaching a value-investing course in Columbia University, gives one of the most concise answers to this:
“…So I ask my room full of smart, sophisticated students to explain why. Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much? Well it’s a good question, so I generally let my students spend some time offering up complicated explanations and theories.
In fact, it is such a good question that professors have developed whole fields of economic, mathematical and social study to try to explain it. Even more incredible, most of this academic work has involved coming up with theories as to why something that clearly makes no sense actually makes sense. You have to be really smart to do that.
So why do share prices move around so much every year when it seems clear the values of the underlying businesses do not? Well, here’s how I explain it to my students: Who knows and who cares?
Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe it’s hard to decide what a fair rate of return on your purchase price is. Maybe people get a little depressed sometimes and don’t want to pay a lot for stuff. Maybe people get excited sometimes and are willing to pay a lot. So maybe people simply justify high prices by making high estimates for future earnings when they are happy and justify low prices by making low estimates when they are sad.
But like I said, maybe people just go nuts a lot (still my favorite).”
My personal view on the reason is probably as wrong as anyone else's, and it is by no means a novel idea. It is also not central to a value investing strategy since all a value investor needs to know is that market prices do not always reflect a fair price. Nevertheless my view is probably relevant for our investors:
Perhaps one reason behind the market inefficiencies is the dominance of short-term traders in exchange trading volumes. The daily buying and selling activity for most securities are so dominated by market participants focusing on short-term returns (e.g. hedge funds, high frequency traders) that the views of long-term investors are reflected with significantly less weight on prevailing prices.
In other words, long-term investors get to cast a lot less votes than the short-term traders in this “voting mechanism”. This means that the short-term guessing game regarding how the market price of a company will change in a quarter/month/day from now can push prices away from the long-term fair price of underlying company, causing a valuation that is disconnected from the long-term worth of the business.
As an example, if the short-term traders believe that Wal-mart’s stock price will fall due to bad economic data that will get published in a few weeks, they can try to get ahead of that price move and sell today, hoping to generate a profit from this short-term move. In cases of large trends such as bad (or good) economic news flow or industry-wide problems, this selling (or buying) can be done with so much capital for such prolonged periods that a large disconnect can develop between the short-term speculators’ equilibrium price and long term investors’ fair price. Since short-term traders have a disproportionately large weight on the market “voting mechanism”, market price would settle at a level closer to their equilibrium price, presenting a buying (or selling) opportunity for the long-term investor.
This hypothesis would be aligned with the observation that markets are significantly better at predicting good or bad news coming up in three to nine months, while consistently failing to reflect the true long term value of businesses few years into the future. As we will see in one of our investment, even the largest companies in the world can (and do) generate returns greater than 20-30% within 3-month periods despite having absolutely no change in the underlying business fundamentals.
Such cases of price disconnect create an outstanding advantage for investors who understand how to value businesses, how to think about market prices, and how to take a long-term view in investing. This is precisely the advantage we seek to capture and profit from in Stylus Capital.