Friday, 10 February 2012

A notable feature of value investing is its strong performance in periods of overall market decline.

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

  • Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further
  • Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. 
  • When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.


In early 1987 the shares of Telefonos de Mexico, S.A., sold for prices as low as ten cents. The company was not doing badly, and analysts were forecasting for the shares annual earnings of fifteen cents and a book value of approximately seventy-five cents in 1988. Investors seemed to focus only on the continual dilution of the stock, stemming from quarterly 6.25 percent stock dividends and from the issuance of shares to new telephone subscribers, ostensibly to fund the required capital outlays to install their phones. The market ignored virtually every criterion of value, pricing the shares at extremely low multiples of earnings and cash flow while completely disregarding book value.

In early 1991 Telefonos's share price rose to over $3.25. The shares, out of favor several years earlier, became an institutional favorite. True, some improvement in operating results did contribute to this enormous price appreciation, but the primary explanation was an increase in the multiple investors were willing to pay. The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.

Ref:  Margin of Safety by Seth Klarman

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