One-upmanship
It's a war out there. Between them and them; who else? Value investors, who always like to keep themselves in good humor and all others. I really don't know what's with the value investors and their value investing. I have mentioned it many times before, there is no such thing as value investing at all. It is either investing, or it is not. It's not investing, if the investor does not find value in it. For an investor, it is always about price and value. The crazy lots, who call themselves value investors and go around trying to punch all others (investors) in the face, are up to something. Well, to begin with, their favorite punching pad is CAPM, which talks about risk and reward.
The CAPM and margin of safety
What CAPM says is that you segregate the risks into systematic (market risk) and unsystematic (firm-specific) risk. Then it goes on to say that firm-specific risks can be mitigated through diversification; but market risk cannot be, and therefore, needs to be compensated. Market risk is measured by volatility in prices of securities, which is called beta. As per CAPM, the expected return for equity investors is calculated by adding beta times equity risk premium to the risk-free rate.
Value investors find all kinds of problems with this formula, and therefore, use something called the margin of safety. They say higher risk cannot be compensated by increasing the expected rate of return (the discount rate), but it suits them very well when they increase the margin of safety.
The irony of business valuation
Expected returns cannot be calculated with precision; as a corollary, we cannot value a cash flow producing asset with accuracy either. Value of an asset is the present value of all cash flows discounted at the appropriate rate of return. Alas, we cannot predict cash flows accurately; neither can we know the expected rate of return from the asset in advance. The irony of valuation is that we cannot value an asset with accuracy. If that is the case, why struggle with it?
It seems both camps are missing this point. When cash flows are uncomfortable, value investors increase their margin of safety, while other investors increase their discount rate. And the war begins. In fact, I have found value investors, for all their hypocrisy, increasing both the discount rate and margin of safely.
The ideal situation would be to know the future cash flows with certainty, and then use the risk-free rate as the discount rate. That would be your expected rate of return. It would then be equivalent of a risk-free asset, say, government treasury. A business is not a treasury because it has very different set of cash flows, and more importantly uncertain cash flows. Businesses are riskier than risk-free securities. So let's not pretend.
The alternative
When we are not in an ideal situation, we have to look for an alternative model for achieving our goals. We invest because we need to increase our purchasing power in future; we need to be well ahead of the beast called inflation. We need to be compensated for the uncertainty of future. There is no other reason really. So how do we go about it?
Well, we need to debunk the widely accepted economic theory called efficient markets. What efficient markets theory says is that market knows everything about the asset; and therefore, its prices are always equal to its value. Because of this, no one can make excess profits out of investment; beating the markets is impossible. If we believe in the efficient markets theory, we have no other models available; just buy the market, and take what it gives.
If we hold that markets are not always efficient, we are on to something. Then the whole world of opportunities opens up. This is how investors should approach risk, business valuation, and expected returns. There lies the edge for the investors over the EMT proponents.
Markets are stupid more often
It is far better to consider the expected rate of return based on the opportunity costs. These are dependent upon the alternative opportunities available for the investors. Inflation and interest rates play a dominant role in estimating an investor's opportunity costs. It is vital to know that different investors have different opportunity costs at the same point in time because of the differences in skills and behavior. Consequently, for the same asset, their expected rate of return could be different.
Back to risk and reward. The actual realized return is a function of the price paid; the lower the price, the higher the rate of return. Therefore, again as a corollary, the lower the price paid, the lower the risk assumed; and consequently, the higher the expected rate of return. This is the crux of the risk-reward concept. That should always be the case as opposed to increasing discount rates or margin of safety to compensate for risks. The earlier the investors, including those value investors, get it, the better it is for them.
To realize the expected return, three things are important: One, there should be mispricing of securities, i.e. there has to be adequate gap between price and value. Smart investors know that there will be numerous such occasions where markets become inefficient, stupid, and irrational. Two, investors should recognize the mispricing, and act on it. They should buy when price is much lower than the intrinsic value; and sell (or short) when it is much higher. Three, the markets should eventually correct the mispricing and become efficient.
To play this game, you need two things: One, ability to analyze value with price. This involves both quantitative and qualitative approaches; and both are judgmental rather than specific. Two, patience to wait for the opportunities. Investors will be better off shunning greed, fear, and envy; they have no place either in life or in investing.
The advice then is to look for the securities priced much lower than their intrinsic value, and then wait for the market to correct the mispricing. Look for the opportunities where prices become attractive enough to realize the expected returns. We cannot realize higher returns by increasing discount rates or margin of safety. That's stupid.
There is more than one way to select securities. We can make our analysis less complicated by selecting predictable, stable, high quality businesses. Otherwise, the prices will have to be unduly attractive for investment.
Markets are stupid more often
It is far better to consider the expected rate of return based on the opportunity costs. These are dependent upon the alternative opportunities available for the investors. Inflation and interest rates play a dominant role in estimating an investor's opportunity costs. It is vital to know that different investors have different opportunity costs at the same point in time because of the differences in skills and behavior. Consequently, for the same asset, their expected rate of return could be different.
Back to risk and reward. The actual realized return is a function of the price paid; the lower the price, the higher the rate of return. Therefore, again as a corollary, the lower the price paid, the lower the risk assumed; and consequently, the higher the expected rate of return. This is the crux of the risk-reward concept. That should always be the case as opposed to increasing discount rates or margin of safety to compensate for risks. The earlier the investors, including those value investors, get it, the better it is for them.
To realize the expected return, three things are important: One, there should be mispricing of securities, i.e. there has to be adequate gap between price and value. Smart investors know that there will be numerous such occasions where markets become inefficient, stupid, and irrational. Two, investors should recognize the mispricing, and act on it. They should buy when price is much lower than the intrinsic value; and sell (or short) when it is much higher. Three, the markets should eventually correct the mispricing and become efficient.
To play this game, you need two things: One, ability to analyze value with price. This involves both quantitative and qualitative approaches; and both are judgmental rather than specific. Two, patience to wait for the opportunities. Investors will be better off shunning greed, fear, and envy; they have no place either in life or in investing.
The advice then is to look for the securities priced much lower than their intrinsic value, and then wait for the market to correct the mispricing. Look for the opportunities where prices become attractive enough to realize the expected returns. We cannot realize higher returns by increasing discount rates or margin of safety. That's stupid.
There is more than one way to select securities. We can make our analysis less complicated by selecting predictable, stable, high quality businesses. Otherwise, the prices will have to be unduly attractive for investment.
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