Investing - Falling Knives: Part 2

A continuation from Part 1.

The results of the Brandes Institute study indicate that falling knives appear to offer potential for substantial out-performance. At the same time, these stocks also seem to carry a material risk of bankruptcy. This presents an obvious challenge: when contemplating investing in falling knives, how can investors distinguish between “butcher knives,” which might be headed for bankruptcy, and “butter knives,” with more promising characteristics?

First, we note that an investment in any falling knife by itself may entail more risk than is appropriate for most investors—and Brandes does not offer a foolproof means of distinguishing between winners and losers. Accordingly, we believe investors considering falling knives should do so with guidance from their financial advisor and in the context of a diversified portfolio. Put another way, we think the challenge is not just spotting butter knives—it’s catching them with a diversified “bucket” of other holdings.

In his books Security Analysis and The Intelligent Investor, Ben Graham—widely considered the father of value investing—urged investors to search for opportunities among out-of-favor stocks. Underlying this approach is that, in the short term, investor psychology sometimes pushes prices for these stocks well below their true long-term values. By purchasing out-of favor stocks, value investors aim to benefit from the broader market’s impulses and mistakes. Falling knives certainly qualify as out-of-favor stocks: their rapid, substantial price declines are obvious signals of intense investor disdain.

So how do value investors decide which to invest in and which to avoid?
Core elements of the value strategy—the calculation of intrinsic value, the incorporation of a margin of safety, and the maintenance of a long-term perspective—are designed to pinpoint and profit from attractive opportunities among falling knives and other stocks. We believe that these principles help investors avoid potentially dangerous investments and focus on compelling prospects.

What is intrinsic value, exactly? And how is it calculated in practice?
To answer the first question, we’ll share a definition provided by Warren Buffet in a 1996 publication to shareholders of his company, Berkshire Hathaway. “Intrinsic value can be defined simply,” Buffet wrote. “It is the discounted value of the cash that can be taken out of a business during its remaining life.” In other words, a company’s intrinsic value is equal to the value today of all of the money it will deliver in the future.

So how is intrinsic value calculated?
Value investors emphasize an approach based on thorough research and analysis of current and historical fundamental company information. The company’s product lines, for example, are studied in great detail, and its strengths and weaknesses relative to its competitors are appraised. Historical profit margin figures are gathered and evaluated, with particular attention paid to results during difficult times. Financial strength is measured using metrics such as ratios of debt-to-equity and cash flow-to interest expense. From there, value investors typically calculate intrinsic value by focusing on earnings, cash flow, and other indicatorsof the company’s wealth creation potential. Alternatively, an intrinsic value estimate is sometimes calculated based on an analysis of the value of the company’s assets less its liabilities. Once calculated, intrinsic value is divided by the number of shares outstanding to arrive at an estimate of intrinsic value per share. Then, this per share value is compared with the company’s stock price. If the stock price is low enough to offer a significant discount to intrinsic value, the stock is purchased. Importantly, value investors don’t expect to be able to come up with intrinsic value estimates for every stock in the market. Firms operating in nascent, rapidly changing industries, for example, are often surrounded by levels of uncertainty that make any estimates of underlying worth dubious. In cases like these, value investors recognize the limits of their abilities and move on to evaluate other companies.

In The Intelligent Investor, Benjamin Graham challenged himself to “distill the secret of sound investment into three words.” He chose “margin of safety.” Simply put, the margin of safety represents the difference between a company’s stock price and its intrinsic value. Value investors believe that the larger this margin, the safer the investment. By buying stocks trading at substantial discounts to their estimated intrinsic values, Brandes aims to create a protective barrier at the portfolio level that insulates against future uncertainty. Some holdings will inevitably encounter the occasional stumbling block, and a margin of safety helps provide protection. Value investors expect that, as the broader market recognizes the inherent worth of an undervalued company, its share price will climb toward its intrinsic value. Of course, this process often takes time. As a result, Brandes exercises patience and manages holdings from a long-term perspective. Typically, we expect to hold a stock for 3 to 5 years, or until the company’s stock price climbs to our estimate of its intrinsic value. Another important quality at the foundation of the value philosophy is independence—the willingness to think differently. As believers in the opportunity inherent in out-of-favor stocks, we don’t follow the investment crowd. Instead, we search for prospects that the crowd has neglected or—as in the case of falling knives—that the crowd has scorned.

Overall, we recognize the risks associated with falling knives. At the same time, we think that select falling knives offer strong potential. And we believe that value investing—with its emphasis on concepts like fundamental analysis, a margin of safety, and a long term perspective—can help identify the most promising falling knives and incorporate them into a diversified portfolio.