Source: Smart Investors
Author: Gu Rong

1. Investors' attitude towards risk

According to Karaman, it has been emphasized time and again that the future is unpredictable.Investors who are trying to avoid losses must allow themselves to survive in all circumstances until they achieve prosperity.

Bad luck may also befall you, and investors may make mistakes.

Just like a river flowing across an embankment may only happen once or twice in a century, yet you still insure your home every year.

The Great Depression or financial panic may only occur once or twice in a century. Based on this, farsighted investors are willing to forego short-term returns as insurance premiums for unexpected disasters.

Sometimes investors make the mistake of setting specific return targets for their investments. Karaman pointed out this mistake: Investors cannot achieve higher returns by thinking harder or working longer hours.

All investors can do is follow a strict method that is always subject to discipline, which will eventually pay off over time.Setting specific return targets only makes investors focus more on the potential for growth, thereby ignoring the risks.

Karaman pointed out that instead, what investors should focus on is setting targets for risk rather than return. Most investment methods don't focus on avoiding losses; only value investing does this.

2. The importance of safety margins

Karaman pointed out that value investing will conduct a conservative analysis of potential value, combined with the necessary discipline and patience to buy only when the price is sufficiently low than the potential value.

Value investors need to strictly abide by discipline when looking for bargains, which makes value investing seem very much like a risk-averse method.

The biggest challenge for value investors is maintaining this required discipline.Being a value investor often means standing with diverse groups of people, challenging conventional wisdom, and opposing today's popular investment style.

It can be a very lonely task.

For a value investor, the ball must not only be in his batting area, but also in his “most ideal” batting area.

When investors are not pressured to invest prematurely, the results achieved are optimal.

(Smart investment: Therefore, in investing, it is very important not to put yourself in a situation where you are caught too much, especially in situations where your movements are deformed. (And before that, you have to do a lot of safe actions to avoid losing your mind.)

Sometimes dozens of good bulls are continuously invested in investors. For example, in a panicked market, undervalued securities will increase a lot, and the degree of undervaluation will also increase. Investors must carefully find the most attractive investment opportunities from these bargains.

However, in a bull market, undervalued securities will become increasingly scarce, and value investors must be strictly disciplined to ensure the integrity of the valuation process and limit the prices paid.

In fact, the so-called “safety margin” is to evaluate the intrinsic value of an enterprise in a conservative manner and compare it with the market price to determine the size of this gap.

The importance of a margin of safety was highly valued by Graham and Buffett and viewed as the foundation of value investing.

Karaman reminded investors,Identifying the intrinsic value of a business is difficult, and it won't be set in stone.

Factors such as macroeconomics and industry competition will all change the potential value of an enterprise, so the possibility that corporate value continues to decline is a dagger inserted in the heart of value investment.

Value investors place great trust in the rule of evaluating value and then buying at a certain discount, but if the value of the enterprise is greatly depreciated, then how much of a discount is sufficient?

Value investors should be concerned about a possible decline in corporate value, and there are three responses that should be effective:

First, investors always give conservative assessments and pay attention to worst-case settlement value and other methods;

Second, investors who are concerned about deflation can ask for more marginal safety discounts;

Finally, the prospect of asset depreciation heightens the importance of investment time and catalysts that deliver potential value.

According to Karaman, investing is not only a science, but also an art.

Investors need a margin of safety. This allows people to make mistakes. Investors can only gain a margin of safety when they encounter bad luck or when the world is complex and unpredictable and extremely volatile.

Charlie Munger once said:Investing is the science of exchanging price for value; the trick is to exchange the lowest price for the highest value.

Karaman also pointed out that the answers to what kind of safety margin investors need to have are not the same; everyone's ability to withstand losses is not the same. There is still disagreement about what margin of safety is appropriate, but there are some elements that can help us make a better judgment.

For example, the company's tangible assets should be given more importance than its intangible assets. Evaluating intangible assets, on the other hand, requires some art.

In fact, more and more outstanding investors, including Buffett, are aware of the great value of intangible assets. They can continue to grow on the basis of minimal capital reinvestment. Ultimately, all cash flow generated by these intangible assets is free cash flow.

But there's no doubt that intangible assets are more difficult to evaluate.

Investors should not only focus on whether their current holdings are undervalued, but also include “why” they are undervalued.

On the surface, understanding the margin of safety is to confirm the intrinsic value of the investment enterprise. In reality, however, there is a major misunderstanding. A margin of safety doesn't seem to be different from an enterprise valuation.

I've always been puzzled about this before, because whether it's an assessment based on a balance sheet or an assessment based on future cash flow discounts, it seems like a rigorous science.

However, I understand that evaluating the intrinsic value of an enterprise based on the concept of safety margin is not the same as that: value investors evaluate safety margin, which is based on conservative expectations.

Rigorous value investors are always critical in judging the rationality of an enterprise's asset value, and their expectations for the future are always conservative.

Throughout the history of investing, the first investors have sought a margin of safety based on tangible assets, such as the margin of safety provided by Graham's net working capital (net current assets) discount.

However, as the market gradually matures and value investment is widely recognized, this margin of safety is becoming more and more scarce. With the exception of a few extreme times, the US stock market rarely provides such opportunities on a large scale.

However, with the rise of the tertiary sector and the modernization of the industry, there are more and more companies that operate on a light asset basis, making investors have to shift their attention to intangible asset evaluation.

On the one hand, this makes it more difficult to invest in value, and on the other hand, it can easily lead to larger market bubbles (because the difficulty of evaluating intangible assets makes investors more dependent on future expectations when investing, which often lead to unrealistic blindness).

3. Value investment shines brightly in a declining market

Karaman believes that securities held by value investors need not be supported by very high expectations; on the contrary, they usually don't cheer for such high expectations, or simply ignore them.

One prominent characteristic of value investing is that it can achieve excellent performance during periods of overall market decline.

In any case, as long as the market does not fully reflect fundamental values in prices, investors can obtain a high margin of safety.

The price of some securities in a falling market is like these companies are going to have trouble, and a change in perception will benefit the price of such securities.

If investors refocus on the strengths of these companies rather than their difficulties, prices will rise. When fundamentals improve, investors can benefit not only from improved performance, but also from rising valuations of these securities.

Karaman's meaning is simple: it is only when the market falls sharply that it is possible to provide value investors with more opportunities.

Because of the panic of falling markets, people often focus on current difficulties and extend the difficulties of a short period (this short period may be years, or even 10 years) to the future.

Once the trend is reversed, value investors can benefit from the double benefits of performance recovery and valuation recovery.

However, in a typical upward market cycle, it is very difficult for value investors to try to find investment targets with a margin of safety. Investors at this time are, on the contrary, relatively more relaxed.

Therefore, from another perspective, value investors in a normal market need great experience and self-discipline to find “relatively undervalued” varieties with a margin of safety.

However, in a market that is panicking and collapsing, what value investors need even more is boldness: for example, under the financial real estate collapse in the 1960s, the reason Li Ka-shing dared to buy large amounts of land for expansion was that he decided that Hong Kong would only get better and better in the future. This seems impossible to make rigorous reasoning from a factual perspective.

whereasHistorically, after every economic catastrophe, optimists at this time have always had greater success.

4. Three elements of value investment philosophy

Karaman pointed out that the value investment philosophy has three elements: first, value investing is a bottom-up strategy; second, value investing pursues absolute performance rather than relative performance; and finally, value investing is a risk-averse method.

In terms of bottom-up investment strategies, many professional investors choose stocks from the top down, that is, to predict macroeconomic trends and the prospects of industry companies, and analyze how other investors will react to decide whether to invest and what kind of investment types.

Investors who adopt a top-down investment strategy must make accurate and accurate information judgments and predictions, and be fast.

Value investors always seek absolute returns and don't pay much attention to the relative returns of investments in the short term.

Most fund managers clearly seek relative returns, especially short-term performance, and as a result, are sometimes forced to follow market trends and trade stocks.

And value investors don't need to worry about these issues; they can boldly pursue varieties that have attractive long-term returns but may not perform well in the short term.

The idea of high risk and high return is wrong. Karaman believes that the market is often ineffective, and that high risk sometimes does not bring high returns. Similarly, low risk sometimes brings high returns.

(Smart Investment: Regarding the perception of risk, Howard Max explained in detail in the book “The Most Important Thing in Investment”. Yes, most people are wrong about the “common sense” that if you take a higher risk, you can get a high return. (This unbiased perception determines how we face our own investment decisions.)

Many investors misunderstand risk. A bond is risky when it defaults, but paying a bond at maturity does not mean there is no risk.

Investors determine low risk may be when they know that the risk will not be greater than the investment decision after the investment is over.

Karaman believes investors can only do a few things to deal with risk: invest sufficiently; invest with sufficient diversification; hedge if appropriate; and invest with a margin of safety, where a cheap price can provide a cushion when mistakes are made.

Investors must be aware that the cornerstone of value investment - the margin of safety - is also a relatively vague concept. To be precise,A true margin of safety will only occur for a very small period of time.

This is one of the reasons why Graham declared in his later years that he had abandoned his belief in value investing: it was already difficult to find very cheap stocks in the US at that time.

In a country's stock market where the market value of a large number of blue-chip stocks is lower than net assets, or even net working capital, value investment can truly play its theoretical role. But most of the time, value investors must face an embarrassing situation: being forced to raise the “margin of safety” requirements or become trend investors.

This is probably the saddest point of value investment theory.

5. The art of enterprise evaluation

Karaman directly defines corporate valuation as an “art.” It can be seen that he believes that corporate valuation is not a rigorous science; it depends more on investors' personal experience, knowledge, and even intuition.

Karaman even pointed out that not only is enterprise value difficult to accurately measure, but it will also change with the passage of time and macro-and microeconomic fluctuations. Investors cannot clearly judge corporate value at a certain point, and they must constantly reevaluate their own predictions of corporate value.

Any attempt to accurately assess the value of an enterprise will result in inaccurate evaluation results. Simply put, “garbage in, garbage out.”

Graham has made this clear for a long time.

In “Securities Analysis,” Graham once said: The purpose of securities analysis is only to determine whether the value is sufficient to support the purchase of a type of bond or stock; a rough measurement of intrinsic value may be sufficient to achieve this purpose.

Karaman proposedThree ways to evaluate the value of a company by value investment:

The first type is the analysis of continuous operating value, that is, the net present value NPV method, which calculates the discounted value of the total cash flow that an enterprise may generate in the future. The price of previous M&A transactions of comparable companies is also used as a measure.

The second type is the liquidation value method, which considers the highest valuation of each asset of the enterprise, regardless of whether it is bankrupt or not.

The third type is the stock market value method, which predicts what kind of price an enterprise will trade in the stock market after it is spun off, and uses this as a standard for evaluating value.

For the first important assessment method, predicting a company's future cash flow or profit growth is a dangerous job. Investors should not fall into blind confidence or expect too much from growth stocks.

However, some sources have higher predictability. For example, the increase in earnings brought about by population growth needs to be determined, and in addition, the profit growth stability of enterprises whose consumption habits are difficult to change will be slightly more stable.

Overall, finding sources that are likely to increase a company's revenue is much simpler than predicting how much the final business revenue will increase and how these sources will affect profits.

How can investors analyze things by predicting the unpredictable? The only answer is to stay conservative. Securities can then only be purchased at prices well below value assessments based on conservative predictions.

The choice of discount rate is also subjective. Many times, investors will give a discount rate that is too low in a low interest rate cycle, but in reality the interest rate cycle always fluctuates, and investors should not use the market interest rate for a specific period as the discount rate.

Generally speaking, even discount rates should be conservative. A higher discount rate, such as a 10% to 12% discount rate, would be safer.

Buffett is said to like to use the 10% discount rate, and he also claims that he likes to use long-term US Treasury yields as the discount rate.

6. The reflective relationship between market price and potential value

Karaman specifically pointed out that one complex factor in securities analysis is the reflexive relationship (Reflexive Relationship) between stock prices and potential corporate value.

That is, the principle of reflection that Soros believes in:Stock prices can sometimes have a huge impact on corporate value. Karaman believes investors must keep this possibility in mind.

For example, when a bank's capitalization ratio (capital adequacy ratio) is insufficient, if its stock price is high, then the bank can issue new shares and fully capitalize itself (increase capital adequacy ratio). This is a form of self-fulfilling prophecy (self-fulfilling prophecy). At this time, as long as the stock market says there is no problem, then there is no problem.

However, if the stock price of this bank, which is in urgent need of additional capital, is low, there may even be a situation where the bank directly goes bankrupt due to its inability to replenish capital. In this way, the negative self-fulfilling prophecy has come true.

(Smart Investment: This year's crisis events such as the US Silicon Valley Bank and Signature Bank are a true picture of this “negative cycle” phenomenon.)

Sometimes, the same is true for companies that use highly leveraged financing and whose debts are about to mature. Market prices may directly lead to fundamental changes, thus providing a better reason for market prices.

Noticing the bank's reflectivity problem, it can be said that it is one of the cases that most fully reflects the principle of reflectivity.

Seth Karaman's book is worthy of being one of the most collectible value-investing classics. Personally, I think it is sufficient to be placed on a par with the book “The Smart Investor” as an introductory model for value investing. However, in terms of rigor, it is still not comparable to “Securities Analysis.”

One of his last speeches at MIT in October 2007 was, I think, the kind of classic that can be printed and placed at the bedside. The title of the article is also classic: “Being able to sleep at night is more important than anything else!” , the last sentence is also a warning:

Investors should always keep one thing in mind — the most important measure is not the return achieved, but the return obtained in relation to taking the risk!

For investors, a good night's sleep is more important than anything else!

7. Value investment and reverse thinking

Karaman believes that value investing is essentially reverse investment.

He pointed out that unpopular securities may be undervalued, while popular stocks will almost never be undervalued. So, if value investing is unlikely to appear in securities that are being bought by people, then where is value likely to appear?

According to Karaman,Value comes when sold off, unnoticed, or ignored.

However, it can be difficult for investors to become reverse investors because they are never sure if they are right and when they will be able to prove that they are right.

Because they have to work against the crowd, reverse investors almost always made a mistake in the beginning. Also, it is possible to incur book losses over a period of time.

However, those who operate with the crowd are almost always right during the initial period.

Inverse investors are not only initially wrong; compared to others, they may even have a higher error rate, and their mistakes may last longer. Because market trends can keep prices out of value for a long time.

Thinking backwards doesn't always help investors; when widely accepted opinions don't have an impact on rival securities, there's no benefit from going against the current trend.

However,When mainstream opinions do influence outcomes or probabilities, reverse thinking can come in handy.

For example, when people flocked to buy home health care stocks in the early 90s, the price of such stocks was greatly boosted, and therefore reduced the returns. At this point, most people had changed the risk/reward ratio, but were unaware of it.

And when most investors ignored and critiqued Nabisco in 1983, when the company's stock price was lower than that of other excellent companies, the risk/reward ratio became more favorable, thus creating opportunities for reverse investors to buy.

The reverse investment in Karaman's words is not an easy tone. This also resonates with John Neff, a value investing master who once described the essence of value investing in this way:”Value investing means enduring pain after buying”.

He said how naive is the idea that value investment means buying and then waiting for a successful harvest.

Going against the mentality of the mainstream public can sometimes leave investors in a very embarrassing situation, yet Charlie Munger knows him very well.

He pointed out that thinking backwards is always beneficial, but the key to your success is not that you think against the public, nor whether others agree with your views, but whether your reasoning is correct and the facts on which it is based are true.

8. How much research and analysis is enough for value investors?

Karaman asked this very thought-provoking question.

He pointed out that some investors insist on trying to obtain all information related to their upcoming investments and conduct in-depth research on enterprises. They will study the industry and enterprise competition situation, communicate with employees, industry figures, and analysts, learn about the company's management, and study the company's past financial data.

Such diligent research is commendable, but there are two shortcomings in this approach.

First, no matter how hard investors try, some information will always be lost, so investors must learn to adapt to insufficient information.

Second, even if investors can know all the information associated with an investment, they won't necessarily be able to benefit from it.

Karaman's assertion may seem very puzzling at first glance: if such hard research and effort to obtain all the information does not guarantee the success of the investment, then what should value investors do? He then analyzed:

“That's not to say fundamental analysis isn't useful, but information generally follows the 80/20 principle: the first 80% of the information can be obtained in the 20% time it initially took. Business information changes easily, and trying to gather all the information will only reduce investor returns.”

Generally, high uncertainty is often accompanied by low prices. However, as the uncertainty gradually disappears, prices may have already risen.

Thus, while value investors may not have the final answer yet to be answered, low prices can provide them with a margin of safety. Other investors, on the other hand, may miss out on buying at a lower price by studying these remaining side effects.

According to Karaman,Value investment research is the reduction of large amounts of information to information that is easy to manage. The research process itself does not generate profits; profits will only be realized later. Investors only need to find undervalued investment opportunities found during the research process, and ultimately the market realizes value.

His meaning is quite similar to “three thousand weak water, I only take one scoop to drink”. These are also many institutional analysts. Although they are familiar with several research companies, most are still unable to turn their own research results into profit.

The difficulty of investing can be seen.

Editor/jayden