The Fallible Investor

Does the business look like a bargain? 

My default assumption is the market has priced the business correctly 

I assume that the market price of any business is correct until I can provide strong arguments otherwise. I agree with Klarman when he says; “a bargain should be inspected, and re-inspected for possible flaws.”[1]

Why businesses can be a bargain

I think a business can be a bargain because other investors can overreact to negative events that affect the business. I think the following reasons usually cause this overreaction:

a)     A herding or cascade effect;

b)     A negative feedback process; [2] or,

c)     Forced selling from margin calls.

How I decide that a business is a bargain

I think a business is a bargain when I can buy it for a 40% or more discount from my estimate of its intrinsic value.

What is the intrinsic value of the business

As discussed, the intrinsic value of the business is what I think the business is worth to a rational businessperson. I estimate this intrinsic value by calculating the expected value of the business based on an upside, central case and downside scenario.

Why I need a ‘discount’ to intrinsic value?

I refer to the 40% or more ‘discount’ from my estimate of a business’s intrinsic value as my ‘margin of safety’.[3] I show this by the diagram below:

I need a margin of safety to protect myself from the risk that I have overestimated the business’s intrinsic value and paid too much for the business. This could happen because:

a)     I acted emotionally and did not value the business properly;

b)     I did not understand some important qualitative or quantitative aspects of the business; or,

c)     I made the wrong conclusions about the business.

Theoretically, a ‘margin of safety’ should not be necessary because I could overestimate the value of some businesses and underestimate the value of others and over the long run, these errors should offset each other. However, I believe I need a ‘margin of safety’ because I suffer from some behavioural biases (especially being too optimistic) which make it far more likely that I will overestimate, not underestimate, the value of businesses.[4]

Why I have the same ‘margin of safety’ for all businesses

I have a ‘margin of safety’ to protect myself from the risk that I have overestimated a business’s intrinsic value. I think the risk of me making this error is similar for most businesses in my circle of competence, and, therefore, I need the same ‘margin of safety’ for each business. Adopting this approach also means I do not complicate my valuation process any further.

More to come..

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[1] ‘Margin of Safety’, Seth Klarman, 1991.

[2] These herding and feedback effects probably occur because, as Dreman points out: “…the vaguer and more complex a situation, the more we rely on other people, both for clarification and as touchstones for our own views. This helps us reduce our uncertainty toward our own beliefs”. P377, ‘Contrarian Investment Strategies: The Next Generation’, David Dreman, 1998. Also, see ‘Behavioural Investing’, James Montier, 2007 for an explanation of what is a herding effect, cascade effect, and a negative feedback process.

[3] A term first used by Benjamin Graham and David Dodd in their hugely influential book; Security Analysis, First Edition, 1934.

[4] See, ‘Behavioural Investing’, James Montier, 2007.