Black swans—a value investor’s close friend
The question to ask about each stock that one is looking at is whether the future cash flows are going to be affected? And if yes, then to what extent?
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Black swans, or other news-making external events are, are typically immediately followed by a strong market reaction. After such an event, the market usually reacts irrationally in the classical fight or flight situation and chooses flight. The market predictors have a field day explaining the causes of the market reaction and providing the sophist reasoning behind them.
The value investor, however, chooses to ‘fight’. The value investors get busy analysing stocks and seeing which have become available at a discount to their intrinsic values.
Of course, sometimes the intrinsic values of some stocks could also change and the value investor accounts for that. It pays to remember that the intrinsic value is the present value (based on an appropriate discount rate) of the future cash flows in perpetuity.
The question to ask oneself about each stock that one is looking at is: will the future cash flows be affected? And if yes, then to what extent? What is the maximum extent to which they could be negatively affected?
Further, is the long-run discount rate impacted? Why? If none of these factors are impacted, then those stocks’ intrinsic value is intact.
But if there is an impact, then there is a new conservative estimate of their intrinsic values.
Are they available below their intrinsic value? If they are available at a significant discount to their intrinsic values, say 30% or more, then it is definitely worth thinking about starting to buy them.
Of course, the sophisticated value investors had already got a huge watch list ready with their estimates of intrinsic values and as soon as there is a black swan event or any other event that causes a huge dislocation in the markets, they are ready quickly, asking the above questions, answering them and then acting on the “buy” list.
The value investor expects the black swans or pseudo-black swans—events that look like black swans at the time but turn out to be not that impactful as perceived—to take place quite frequently and does the homework beforehand. She has studied a lot of stocks and zeroed in on a fairly large list of stocks which, if available significantly below their intrinsic values, she would like to buy.
During calmer times, she starts with the ‘A’s—as Warren Buffett would put it—and starts rejecting fundamentally weak companies and putting the fundamentally strong companies on her watch list. Further, for each of the companies she has an understanding of the major strategic factors that could have an impact on their cash flows.
Based on that, the appropriate discount rates and hence their intrinsic values are kept ready. Most investors, however, would not keep that precise a tab on the intrinsic value of some of the stocks they prefer but can quickly assess that they are available at a significant discount as they are already aware of the major factors defining that company during an earlier study.
Another process that professional value investors follow is that they have ready models with all the companies in the market available and just feed in the current market prices during or after a black swan event and are thus able to identify a set of companies that seem to be the most discounted.
Then they double check through a stress test to see what factors could be so negative as to impact the cash flows and intrinsic values below the current market price and what is the likelihood of those factors playing out.
This is a reverse way to test the robustness of the value and determine how strong the margin of safety is. Stocks that pass through this stress test on margin of safety can be looked at favourably and probably a quick buy order can be placed.
Speed, however, is not that great a virtue and in case of any doubt, it is important to satisfy oneself that one is doing the right thing rather than try to be agile.
However, one must remember that there will always be some information that is not available or not clear fully. The value investor’s job is not to expect to know every single piece of information.
She should attempt to make sure that the main factors defining the value are handy and assessed properly, including a stress test (remember the 80/20 Pareto principle, that 80% of the effect is caused by 20% of the factors). The lesser known factors and obscure pieces of information of marginal impact can be left for the future and that risk is to be covered by not allocating a large percentage of the investible sum to one single stock.
During such times, a large number of good-quality stocks are available at a discount to intrinsic value and hence a diversified portfolio of such stocks should be bought. This mitigates the potential risk manifestation due to the marginal factors.
Value investors welcome friendly black swans.
Vikas Gupta is executive vice-president and chief investment officer, ArthVeda Capital