Today, it seems as if everyone wants to be a value investor. This year's Berkshire Hathaway (BRK.A)(BRK.B) annual meeting attracted a record attendance. More than 40,000 people traveled to Omaha to hear Warren Buffett speak. That's 40,000 people who are all trying to be contrarian value investors. There are also thousands of value investor clubs around the world, not to mention all the publications devoted specifically to providing advice for value investors and uncovering value stocks.
Unfortunately, for those investors who believe it is easy to be a value investor, nothing could be further from the truth. There is much more to value investing than just buying cheap stocks and holding them for several years, hoping to achieve outperformance in the meantime.
A Different Way Of Thinking
To be a true value investor, you need to have a different way of thinking than the rest of the market. This is why Buffett has been so successful as other fund managers have struggled. He thinks differently than other investors and has what Seth Klarman has labeled the "necessary arrogance" required to profit over the long term.
Klarman made this statement in an article published in Barron's in February 1999. Titled "Why Value Investors Are Different," Klarman used Buffett's acquisition of stock in the Washington Post in the mid-1970s bear market as an example of why the Oracle of Omaha has been able to succeed where so many other investors have failed.
As shares in the newspaper company plunged in the 1973 to 1975 bear market, Buffett "simply decided that the market was wrong. His view was that the sellers were not thinking clearly, perhaps were not in a position to think clearly." Buffett's steadfast conviction was a display of the "necessary arrogance" that is required to make investment decisions. "An investor must have more confidence in his or her own opinion than in the combined weight of all other opinions," Klarman opined. "This borders on arrogance, the necessary arrogance that is required to make investment decisions," he concluded.
The manager of the Baupost hedge fund went on to say that while value investors must have a certain degree of necessary arrogance, this arrogance must be "tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard-working."
Buying And Selling
Value investors need to remember that if they are buying a cheap stock, they are buying it off someone who is selling, who may or may know more about the company and its prospects. The other investors selling, "many of whom are very intelligent and hard-working," may be selling their shares to you at a bargain price due to "ignorance, emotion or various institutional constraints," but these are not the only reasons that could inspire a sale. Holders could also be dumping shares because the "apparent bargain is in fact flawed, that is actually fairly priced or even overvalued and that the sellers know more than you do." As Klarman concluded, "This is a very serious risk."
Therefore, value investors must seek to mitigate this risk with two initiatives: first, with extensive fundamental analysis and second, by knowing "not only that something is bargain priced but, as best you can, also why it is so."
This is the position into which every value investors should seek to put themselves, Klarman noted, but very few really do. True value investing requires rigorous due diligence and risk analysis, plenty of patience and a willingness to go against the herd. Most investors lack these key qualities and are only seeking a shortcut to outperformance. That's what separates committed value investors like Buffett and Klarman from the hobbyists.