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Value Investment Philosophy: Risk and Reward                             


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In general, value investment philosophy is made up of three parts. The first is using bottom-up strategy which identifies specific undervalued investment opportunities. Second, value investing is absolute-performance, not relative-performance based. And third, value investing is a risk-averse approach meaning attention is paid as much to what can go wrong (risk) as to what can go right (return).

This month we take a look at  risk and return. While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return. To the extent that most investors think about risk at all, they confused about it. Some insist that risk and return are always positively correlated; the greater the risk, the greater the return. This is, in fact, a basic tenant of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true. Others, mistakenly equate risk with volatility, emphasizing the risk of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correction between risk and return would hold consistently only in an efficient market. Any disparities would be immediately corrected; this is what would make the market efficient. In inefficient markets it is possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyze, or when investors buy and sell for reasons unrelated to value. It is also common place to discover high-risk investments offering low returns, Overprices and therefore risky investments are often available because the financial markets are biased toward overvalued condition if enough speculators persist in overpaying. Also, unscrupulous operators will always make overprices investments available to anyone willing to buy; they are not legally required to sell at a fair price. By itself risk does not create incremental return; only price can accomplish that.

In the financial markets, the connection between a marketable security and the underlying business is not as clear-cut. For investors in a marketable security that gain or loss associated with the various outcomes is not totally inherent in the underlying business; it also depends on the price paid, which is established by the marketplace. The view that risk is dependent on both the nature of investment and on their market price is very different from that described by beta.

While security analysts attempt to determine with precision the risk and return of investments, event alone accomplish that. For most investments the amount of profit earned can be known only after maturity or sale.

There are only a few things investors can do to counteract risk: diversify adequately,, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.

This is primarily sourced from Seth Klarman’s book entitled “Margin of Safety, Risk-Averse Value Investing Strategies for the Thoughtful Investor” published in 1991 and never published again. The book contains many valuable lessons for the value investor despite it is no longer available.

At Port Wren Capital, LLC, we specialize in picking specific undervalued U.S. stocks using fundamental analysis developed by Benjamin Graham using a five step process. We have beaten the S&P500, DJIA and NASDAQ benchmarks since we started 5 years ago on our own investments. Discover the difference for yourself. To learn more contact us today.

Published: 6/1/19

 

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