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Searching For Value In An Uncertain Environment

|Includes: ABX, Resolute Forest Products, Inc. (RFP)

Searching for Value in an Uncertain Environment

I am starting a blog to share my ideas, interact with other value investors, and increase my investment knowledge. My investment approach is that I am contrarian who focuses on balance sheet analysis more than I/S analyis (as earnings can change quickly). I look for strong FCF generation, little debt, insider ownership. I try to work in disasters and industries that have grim outlooks. I want to buy assets for a discount. I invest for a holding period of 3 to 5 years. People always ask me about catalysts but my answer to that problem is that if you buy cheap enough, the catalyst is already built in.

Value investing is great because it provides you with the highest return with the least risk, there may be other investment strategies that produce higher returns but they usually incur additional risk. In terms of risk adjusted return, there are few strategies that beat a value strategy.

In the past few years, I have devoted a great deal of my spare time in learning the tenents of Value Investing. From reading every book I can get my hands on, to reading annual reports of prominent value investors, to meeting with prominent value investors in the industry.

My journey began by reading Security Analysis (1940 Edition) and the Intelligent Investor and finding securties that were net nets ((Current Assets - All Liabilities)/Total Outstanding Shares)). I would buy only these securities which provided a margin of safety, so basically securities trading below 2/3rds of NCAV. In order to hedge my risk, I would buy a basket of these securities and hold them for an extended period of time. I was not concerned about the businesses these companies were in, I was concerned about cheapness and to ensure that these companies would be able to survive. I found many net nets in Japan in 2010/2011 and ended up selling many of my positions early on this year. My approximated return from this strategy was about 15% Annualized.

One thing that I realized through my analysis of examining current value investors is that many modern day value investors are hybrids of Ben Graham. Some of the traditional deep value guys such as Walter Schloss and Peter Cundill proved that the traditional strategy still worked. Which I think is the most easy to replicate.

We then had the emergence of the value investors who bought great companies at good prices. The Warren Buffett clan, I find this group to be the most popular although is probably a strategy is the most difficult to replicate.

My strategy has evolved over the years from continually using Ben Graham net nets but also being an opportunistic value investor. So companies that are trading at a significant discount to NAV. I try to calculate NAV currently, then a sum of the parts valuations using relative industry multiples and then I finally try to observe what the NAV will look like in three years (this is a strategy that Peter Cundill employed)

As value investors, we are increasingly uninterested in predicting the future. We know that we can't predict the future but we believe that assessing current value with a margin of safety is the best way to protect capital. Searching for bargains is what we do best, and that is all we are focused on. I am not concerned about what will happen in the economy, if we don't find bargains we sit in cash.

I think for any value investor the most important thing is to avoid loss, loss being defined as a permanent impairment of capital. We love volatility as value investors, as it creates opportunity. Most people can't bear to see the value of their stocks go down dramatically, but if you have faith in your analysis, it doesn't matter what the market thinks, time and time again the market has been proven wrong.

When I buy a security, I look at the price once a week. Looking at it more creates myopic loss aversion, I have faith in my own analysis being correct rather than the noise from the market. The crowd is wrong most of the time.

As Howard Marks says, in order to beat the market you have to think differently than the market. So you have to be uncoventional and accurate, in what he describes as second level thinking.

In my opinion, value investing will always provide great returns because it is not a mechanical approach, it is buying what other people don't want. Therefore, I do see alot of people who understand the tenets of value investing but will never be able to apply it because they can't stray away from the crowd. It is difficult as a human to be different from everyone else. This is why it is essential to have conviction in your own ideas, and have a mentality of you versus the world.

Value investments in general have problems but we try to buy securities that are the bottom of the business cycle, if ROIC is 6% currently most people believe that it will trend to even lower. As value investors, we know that this number will go back to the historical average if the problem is not permanent.

The market basically becomes too optimisitic about companies that are doing well currently and overly pessimistic about companies that are currently underperforming. Therefore it is very counter intuitive for someone to invest in a company that has problems than a one that is performing well currently. Once someone can get over this hump, they will be able to reduce risk.

I hear alot of people using a mechanical approach to find value investments such as low P/E, low P/B, Low EV/EBITDA. But value investing is not an exact science, you may find securities that have a high P/E due to earnings underperformance that may be trading below book value or replacement value. Therefore it is not a strict requirement that all value investments trade at low p/e, a low p/e indicates cheapness relative to earnings but that isn't exactly cheap if the company has permanent problems.

Current Environment

The US debt situation has increasingly worsened through the injection of liquidity by the Fed through QE 1-3 and is driving asset prices through the roof.

In my opinion, it is only a matter of time before this massive injection of liquidity will cause problems (inflation). This in turn paired up with the massive debt problem the country faces shows signs of impending doom. No one knows when, but these issues will have to be addressed sooner rather than later.

As James Grant said "a general fatigue animus towards gold," that seems predicated on more confidence in central bankers; to Grant, "that confidence is utterly misplaced!''

As Gold is sinking and equity values are driven up, the roles will be reversed in the future as Ben Graham said in his famous book "today's winners are tomorrow's losers".

Although I am mainly building a cash position, there are some interesting bargains that are still available, which I will touch on in a few days.

With that said, I will leave you with a quote from Seth Klarmans latest annual report " that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing"