Klarman introduces what he calls the three central elements to a value investing philosophy:
1) A “bottom-up” strategy
2) Absolute (as opposed to relative) performance
3) A risk averse approach
In previous chapters it was mentioned that most institutional investors use a top-down approach to investing. That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. Klarman argues that this method of investing is far too prone to error, and doesn’t allow for a margin of safety.
For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.
In addition to these challenges, top-down investors are buying based on concepts, themes and trends. As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.
Institutional investors are judged based on their performance relative to their peers or the market. Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. Absolute investors don’t judge themselves based on their performance to the market, which results in a short-term investing horizon. Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.
In the financial industry, returns are expected to correlate with risk. That is, you cannot generate higher returns without taking more risk. Moreover, downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock’s volatility versus the market).
Value investors think of risk very differently. Downside risk and upside potential are not necessarily the same, and value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.