Value “Trader”

There is a misperception that value investors have to be long term buy-and-hold type. It is not necessarily so. Many hedge funds are value-oriented. While they sometimes hold a few positions longer than one year or even longer, more often they do trade, i.e. owning a position for no longer than a quarter or sometimes even shorter, such as a few weeks. But they’re vaue investors indeed. To understand this issue better, you have to ask yourself: WHAT IS VALUE?

Convensional wisdom is, value is what a stock, or more precisely, a business is worth. Nevertheless, it is too academic an answer without any practical substance. Warren Buffett keeps reminding investors that buying a stock should be viewed as buying a fractional ownership of business. Buffett is one of few investors in the world that can afford to stick to “business” investing discipline and be a truly long term investor. One can certainly try to replicate what Buffett does, but so far with little success even the “Buffett” way of investing is so easily understood. Why? Because investing is not simply science but more alike art. It requires a certain type of personality to replicate Buffett’s investing methodology and not many people share that kind of traits.

So should we give up value investing? Not really. If Buffett is the highest standard of value investing, there are different levels beneath his, many of which should lead to investing success if you know what you’re doing. 

Value, in practical terms, should be interpreted as extremely attractive risk/reward profile of an investment. For example, a stock has a decent chance (well above 50% probability) to double in two years (or annualized return of 41%) with only 10% downside risk from where it’s currently trading, it’s a terrific value idea. Another stock, while having a chance to make 50% return in 6 months, it could drop the same 50% during the same period and both outcome has equivalent probability. This binary outcome situation is not a good value investment – it’s a speculation.

Often there is a confusion about investment and speculation.  The difference arises from assessment of uncertainty surrounding any investment.  Not only do you have a good judgment of probabilities for each different scenario, but you have to get the magnitude of impact in each scenario right. An investment is about avoiding any disastrous downside scenario while participating in above average upside opportunities.

Now let’s talk about VALUE TRADER.

Value is never a singular number. Any stock or business can only be evaluated in a range of values (and, in more sophisticated term, distribution of probabilities for each specific value within the range).  The process of getting the range, particularly the effort of trying to narrow such a range, is integrated part of any serious stock analysis. This analysis reflects an analyst’ understanding of quality of one business, risk characteristics of it and potential  opportunities ahead for this business.

Long-only traditional money managers use the above analysis to determine what is a good entry price for an investment and what is target exit price later. For a trader, however, he can also take full advantage of such analysis.

The market is never perfectly efficient, particularly in very extreme situations, such as panic or bubble times. Nevertheless, market price does reflects the aggregate “opinion” on one stock by market participants, which can be right (coincidence if occurs) or wrong (more likely).

 To profit from such ineffiencies, value investors (or traders) can do two things:

One: using longer than average time horizon (2-3 years or longer, instead of typical 1-2 yrs for most mutual funds) to buy stocks below its intrinsic value, ideally at significant discounts. Typically, it takes half a year to 1.5 yrs to prove “you’re right”. Such tactics are sutiable for long-only funds;

Second: for aggressive investors, e.g. hedge funds that have value-bias, can do the following to take advantage of his knowledge base, professional experience and the market tendancy to overshoot:

I. Calculate a range of intrinsic value, instead of one singular number;

II. Understand what drives the intrinsic value moving to either end of the range, such as underlying cash flow or earnings estimate change (normalized, rather than any specific quarter or year), or events that could influence market perceptions about the business and in turn impact the valution multiple

III. Stress test by employing “Reasonable Worst Scenario” to quantify “absolute” downside risk. This is sort of “predicting price”, which could be effort in vain. But it forces an investor into a trader’s shoes. The caveat is “don’t be carried away by such price prediction”.

The end outcome from the above exercise is, for each stock, an investor should have a range of intrinsinc value in his mind; combined with market instinct, commone sense and trading smart, he can “trade” stocks over a short period of time, say one month.

Why “Value Trader” can win? Because the market is not efficient, and it’s never going to be. Sources of ineffiencies include:

1. Investors often don’t realize for many stocks, the range of their intrinsic value could be quite wide. For example, Rockwell Automation (NYSE: ROK) as of late 2007 has an intrinsic value today at a range of $60-80; and such intrinsic value is growing at a pace around 10%. When ROK hit its high at low-70 in early December 2007 after it released its good CY3Q07 results, the stock was at above the mid-point of intrinsic value range with limited upside left. At the same time, the market condition had started to deteriorate with rising concern about a US recession and West Europe slowdown, the two biggest markets for ROK. A long-only investor will probably at best take some money off the table since ROK has very attractive long term growth story with unique driver from its new techology products. For a value trader, however, it’s a good opportunity to short the stock. Can you see the difference? To a “value trader”, there are only two choices: buy or sell.

2. Many mutual funds often arbitrarily separate value stocks from growth stocks. However, value could turn to growth and vice versa. Such ineffiencies often arise.

3. Many investors tend to oversimplify analysis, particularly paying little attention to out-of-whack scenarios that appear to have low probablity. However, such scenario, if occurs, could dramatically change the risk/reward of an investment. More often, even if such an extreme scenario doesn’t really occur in the end, any newsflow that gives rise to concern that it might happen can significantly change the multiples put on its earnings or cashflow. For instance, agriculture commodity price could rise riduculously higher than people expect today, which will impact many businesses consuming them. Food staple industries could have unprecendented downside risk, something you never run into in the previous recessions.

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