Value, boom and bust

As I observe the uninterrupted upward rush of the Indian stock markets, I can't help but reflect on the principles of value investing that have guided my work as an analyst and author for over three decades. In any rational conversation, hardly anyone even attempts to justify how stock prices behave. It does seem like current high valuations are raising eyebrows and concerns, making it more crucial than ever to revisit and reaffirm the timeless wisdom of value investing. I'm reminded of the timeless wisdom shared by the hedge fund manager Seth Klarman, one of the most respected voices in value investing.

I recently re-read Klarman's insightful letter to investors from late 2009 or early 2010, shortly after the Global Financial Crisis. His observations and lessons, both learned and unlearned, resonate strongly today, although the market situation is quite the opposite. Klarman's perspective on value investing has always struck me as particularly astute, viewing it as a sort of inoculation or genetic predisposition. In my years of experience, I've observed the same phenomenon he describes - some investors grasp value investing principles immediately, while others struggle to comprehend or accept them.

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This dichotomy speaks about Klarman's understanding of investing as the intersection of economics and psychology. On one side, we have the "easy" part: the worth analysis. This involves poring through financial statements, understanding business models, and projecting future cash flows. It's a skill that can be learned and refined over time.

But then there's the 'hard' part Klarman emphasises: personal psychology. This is where even the most seasoned investors can falter. How much should you buy? When is the right time to enter the market? Should you wait for a better opportunity or gradually build your position? These questions plague every investor, and the answers often lie not in spreadsheets or market data but in our own minds.

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Klarman's letter from 2009 offers valuable lessons that are particularly relevant in today's high-valuation environment. One of the most crucial aspects is conservative positioning. He pointed out, "Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return." Maintaining a balanced and cautious approach enables us to think clearly during crises and focus on new opportunities while others are distracted or even forced to sell.

Another key lesson from Klarman is understanding the relationship between risk and price. He astutely noted, "Risk is not inherent in an investment; it is always relative to the price paid." This is a subtle but crucial distinction that many investors overlook. Similarly, we must recognise that uncertainty is not the same as risk. Klarman argues that periods of great uncertainty often drive prices to levels that make securities less risky investments. Surely, the situation today is analogous. Periods of relentlessly rising stock prices make everything riskier.

At that time, Klarman advised, "You must buy on the way down. There is far more volume on the way down than on the backup and far less competition among buyers." Again, should we not reverse the argument in today's conditions?

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Applying these principles to the current Indian market scenario requires a delicate balance. The high valuations we're seeing today demand careful analysis through the lens of value investing. While there may be opportunities, we must approach them cautiously, always considering the fundamental principles guiding value investors through countless market cycles.

Maintaining a long-term perspective is essential, especially in times of exuberance. The markets may continue to climb, but history has shown us time and again that valuations eventually revert to their means. As value investors, our task is to remain disciplined, patient and focused on the intrinsic value of our investments rather than get caught up in short-term market movements.

By understanding the nature of value investing, recognising the dual aspects of investment analysis and personal psychology, and applying the lessons learned from past crises, we can navigate even the most challenging market conditions. As we watch the Indian markets soar to new heights, let's remember Klarman's wisdom: true value lies not in market prices but in the fundamental worth of the businesses we invest in. Booming prices are no more immune to business fundamentals than crashing markets are.

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