Paradox of value investing

Discussion in 'Stocks' started by Cutten, Jul 11, 2008.

  1. Cutten


    How do value investors rationally own stock? According to their methodology, each stock can be valued at a certain price. As an example, let's say stock X is trading at $100, and a value investor comes up with fair value at $80. At what point is it rational to buy? Surely at $79.99 it is now "value" and should be bought, rather than holding cash or index investments? I do not see how it can be rational to wait for lower prices - if the stock is cheaper than the alternatives, a value investor is compelled by their methodology to own it. There now arises the problem - if fair value is $80, how can the investor hold it above $80? Logically the investor is compelled to sell at $80.01.

    Graham and Dodd tried to come up with a rationale for waiting for bigger discounts to true value. Due to risk, uncertainty, illiquidity etc, they said an investor should wait for a margin of safety of 50%. However, they then have the same problem, it's just that the price is different. In the case of stock X, their margin of safety would put a buy point at $40 - half the intrinsic value. So they buy at a huge discount. The problem is, as soon as it goes back to $40.01 or higher, they again have to sell to be logically consistent. If a 50% margin of safety is required to own the stock, then that means 49.99% is not enough. If they would not buy at $40.01 on the way down, then how can they own stock at $40.01 on the way up? Assuming the intrinsic value does not change, the rational value investor can only take 1-2 ticks out of any investment.

    To hold on for longer than two ticks, the calculated intrinsic value must increase each day by more than the stock price appreciation - a rather far-fetched assumption.

    Note that growth stock investors do not have this problem as much, because they are typically buying and holding stocks that are going up to new highs. However, it faces ALL dip-buying investors who do not claim to be able to predict future price. How can you not own something at price X, buy at X minus 1, then hold at X +1? If it is cheap at X+1, then you should have bought at X+1 or X on the way down, shouldn't you?

    Can someone point out the flaw in my logic? Or is all valuation-based investing completely irrational?

    Traders do not face this problem, because they are saying "price is headed higher". Yet almost all investors claim they can't predict price, only valuation. Yet they willingly refuse to own stock when it is undervalued, then after purchase, they hold it when it is at a higher price than before when they refused to own it. Makes no sense to me.

    A secondary paradox comes after exit. If you sell a stock at $100, that means you thought it was a buy at $99.99. But if you think that, then doesn't it become a buy again at $99.99 if it falls back a tick? Thus, all value investors should re-enter their positions as soon as they fall 1 cent.

    N.B. all this assumes no minute by minute change in the valuation. Obviously sometimes news comes out which causes a large shift in value, and then selling and not re-entering makes sense, as does buying and not immediately selling 1-2 cents higher.
  2. a value investor should be defined like that: you should not pay any attention to the price, just like you buy a house, the value is
    you own the house and you enjoy it whether the house price goes down or goes up.

    stock traders think the volatility as value, the more volatile the more value. a no change is no value.

    investors think dividend as value, so they do not care about price. just as you put saving in CD, you care about the CD RATE, that created constant payment after it expires, that is value.

  3. I telling you, those value investors make me want to pull my hair out with their valuations. I chat with a dozen respectable value posters and add what I can, mostly lurk, but they do make the numbers work and provide a rational basis.

    Whatever the price the share is trading at, a case can be made that is below or above value.

    A recent example. pps went from 32 to 30. Fair value posted was 28, before the ink was dry the stock went to 26 and now sits at 24. A new set of numbers will be made why 24 is fair value.

    Ditto going up, fair value is 40 when the stock gets to 40 a new set of parameters (Ie future earning, extrapolated numbers) of why it is now worth 60.

    Some people can point out that the value is dead wrong but unless you can justify why, using fair value metrics, you might as wall talk to the paperwieght on the desk.

    I've seen them discount dilution, as if some magic fairy is going to buy up a secondary.

    I've seen them come up with value which may be half of the stock price and waiting for an entry point which in my book is a falling knife yet somehow it is a "value" as it continues its slide.

    Maybe value investors never work in the present tense. I still take it into consideration and do find it interesting.
  4. Cutten


    That has nothing to do with value investing.
  5. Daal


    my favorite rationalization I hear for this is 'it could be a takeover target' and if you press them that means it was a buy before, they will spit a mathematically illiterate argument and try to move on. of course the real reason they hold its because of greed and a 'feeling' that the price will continue to rise but of course they wont admit that, thats a sin in god buffett's eyes
  6. Not only should it then be bought at $79.99 according to the value doctrine, but bought all the way down. Value investors will typically back up the truck as price falls below perceived 'fair value' derived by their analysis when nothing has changed in the fundamentals. Can end up being very dangerous and painful. Or, it results in 100-baggers.

    I think the danger lies in how you determine what fair value is. How do you value goodwill in fair value? What about sales growth and profit growth, do you simple value that at zero just to be on the safe side? I think the most common among deep value/activist hedge funds (and the most conservative) is usually liquidation value, i.e. how much money will I get back in the worst case if this thing files chapter 11 tomorrow.

    Pabrai loaded up on DFC (Delta Financial) in 2007 as he thought the underlying assets had a higher liquidation value than the stock price was reflecting. Unfortunately for him, he was wrong. It did file chapter 11 and it was a true zero, the market was right.
  7. Buying a stock:

    1. Only buy stocks at a discount to their intrinsic value. This provides you with a much needed margin of safety.

    2. Intrinsic value can be determined in different ways. Different investors will come up with different values for the same stock, all determined using a different method.

    3. An investor stops buying when he has alocated a pre-determined percentage of his portfolio.

    Selling a stock:

    1. A stock is sold when it reaches intrinsic value.

    2. Something substantial changes in the business' operation that affects the intrinsic value of the stock in a negative way.

    3. A stock is sold when a better deal comes along. The investor finds a stock that provides a better place for his capital. The margin of safety could be higher, or the stock has some other attractive features that the market is now discounting, whereas it demanded a large premium for in the past.
  8. Cutten


    This is the thing though - how does it result in 100 baggers? If it's fair value at $80, it's overvalued at $80.01 and must be sold. A true value investor has a maximum profit potential of 2 cents on an investment, assuming that value stays constant.

    The only way around this is the Graham & Dodd "trick" of buying at half fair value, then selling at fair value. But this is logically inconsistent - if it makes sense to own at 99% of fair value on the way up (which is necessary in order to own it and be able to sell at fair value), then it makes just as much sense to own at 99% on the way down. Thus if you wait for a 50% discount, you still have to sell at a 49.99% discount - either that or you have an irrational (from a value point of view) bias to owning on up-trends not down-trends despite identical valuations.
  9. Cutten


    You missed my main point. I'll try to explain it in reference to your points.


    1) Only buy at a discount - fine, I addressed that in my post. Stock X is worth $80 and so we wait until it trades $40 to buy it.

    2) Let's assume we are perfect analysts and can arrive at the exact fair value for the stocks we buy (if we can't, then we pass on them). That's fine and doesn't affect my point.

    3) Stop buying once you reach maximum allocation. Again, that's fine and has no bearing on the point of my argument. Let's say 10% maximum allocation.


    1) A stock is sold once it reaches intrinsic value. Again, I addressed this in my post - I am well aware that this is what value investors do, however I am contending that it is *completely irrational* under valuation principles to buy at a discount and hold to fair value. Re-read my post - I will also elaborate below.

    2) Something negatively impacts valuation. This is obvious, and I already addressed it - if news comes out and makes fair value plummet below the present price, it's a clear sell.

    3) Sell when a better deal comes along. Again, I agree.

    Now, back to the GLARING CONTRADICTION in what you posted.

    You say the reason to wait for a large discount (e.g. 50%) to fair value is to provide a margin of safety. So on the $80 fair value stock, you buy at $40. However, what happens when the stock hits $40.01? You no longer have your desired 50% margin of safety. The margin of safety has fallen below the threshold you demanded. So, how can you hold with a lower than required margin of safety of 49.99%?? Shouldn't you sell the stock?

    And if you DO feel that 49.99% is sufficient margin of safety to continue owning the stock - well then, shouldn't you have bought at $40.01 on the way down when it hit the 49.99% margin of safety? If that smaller margin was enough for you to continue owning the stock and not sell, then it is enough for you to buy the stock on the way down 1 cent higher, and hold.

    By buying at a 50% discount and holding to a 0% discount, you are saying that you are willing to own at discounts from 49.99% all the way up to 0.01% on the way up - but not at the EXACT SAME VALUATIONS on the way down. In other words, you think a stock is both a buy and a sell AT THE SAME PRICE & VALUE. This is completely irrational and contradictory - a stock cannot both be a buy and a sell at the same price & value.

    That's the paradox of value investing. Can anyone resolve it?

    You also overlooked my second point. If you sell at fair value, then if the stock falls back 1 cent, shouldn't you buy again? The only possible reason for not buying back 1 cent lower is if you demand your 50% margin of safety again. But once again, this is totally irrational. A value investor doing this is saying that at $77, $78, $79 the stock was cheap enough to be owned, until he sold at $80 (fair value). Yet as soon as it goes back to $79, 78, 77, now all of a sudden he thinks it cannot be owned? Despite the valuation not changing one cent, he is making a different buy/sell decision at the exact same prices. Completely illogical.
  10. Cutten


    If this paradox is valid, then it poses a severe problem for value investors. It means one of two things. Either:

    i) a value investor cannot rationally wait for major bargains. He must buy the moment a stock becomes 1 cent undervalued.


    ii) a value investor cannot rationally hold on to major bargains for very long. He can only buy at "dirt cheap" and then has to sell 1 cent above "dirt cheap".

    Holding on beyond this 1-2 cent profit means that the investor is using different holding criteria for identical valuations - something clearly irrational on a pure valuation theory basis.

    N.B. I think I have a solution to this paradox, however the solution completely undermines the claims and beliefs of most value investors. I'm interested to see what people come up with.
    #10     Jul 12, 2008