Saturday, August 22, 2009

Waiting for the Right Pitch

This discipline is one of the most important characteristic that distinguishes the value investors from other market participants and the value pretenders. Here is an extract from Seth Klarman's Margin of Safety Chapter 6. By now, you can tell that I am huge fan of this book. This is the equivalent of Ben Graham's Security Analysis updated for the current times, and the lessons I have learnt by reading and re-reading this book over and over again are invaluable.

Warren Buffet uses a baseball analogy to articulate the discipline of value investors. A long-term oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle-an undervalued investment opportunity

Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky

Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if the umpire were calling balls and strikes - mostly stikes - thereby forcing them to swing at almost every pitch and forego batting selectively for frequency. Many individual investors, like amateur ballplayers, simply can't distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do

For a value investor a pitch must not only be in a strike zone, it must be in "sweet spot." Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift his bat from the shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn't want to settle for an investment offering a safe 10% return if you thought it very likely that another offering an equally safe 15% return would materialize soon.

An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. This dual discipline compounds the difficulty of the investment task for value investors compared with most others.

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines. When attractive opportunities are plentiful, value investors are able to sift carefully through all the bargains they find most attractive. When attractive opportunities are scarce, however, investors must exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid. Above all, investors must always avoid swinging at bad pitches.

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