In his book, Margin of Safety, renowned value investor Seth Klarman outlined three areas of opportunity for value investors. In simple terms, three ways retail investors following the value investing path can beat the market and the professionals.
The three areas are catalysts, market inefficiencies and institutional constraints.
Paraphrasing Mr Klarman, value investing can be simple. We want to find "ongoing, profitable and growing business trading at discounts to their conservative estimates of underlying value".
The problem investors face is that the simpler the analysis and the bigger the discount, the more obvious it's a bargain becomes to other investors. Over time, that discount should disappear as investors push the price up closer to the underlying value.
That means we need to dig deeper and work harder to find undervalued opportunities.
Catalysts
One way investors can realise that value is if a significant event occurs that immediately pushes the price up. Events, or catalysts, can be something under a company's control while others could be external. Selling off non-core assets, signing a large valuable contract, share buybacks, asset sales or simply a change in management could all be internal catalysts that rerate the stock price.
One example might be Woolworths Limited (ASX: WOW) management taking action to increase its competitiveness with arch-rival Coles and discounter Aldi, drastically reducing losses from its Masters business – either by selling it off, or some other strategy.
External catalysts could be soaring prices for the commodity a company produces, changes in exchange rates or interest rates, and a takeover offer – such as the surge in M2 Group Ltd's (ASX: MTU) share price thanks to a friendly merger proposal from Vocus Communications Limited (ASX: VOC).
Market inefficiencies
Small cap companies – or those outside the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) are not as widely researched and covered by investment bank analysts. Small cap fund managers often find it easier to beat the market than their larger counterparts, simply by finding under-researched companies. The less researched a company, the more chance there is to find those that are undervalued, giving small cap investors a bigger chance of beating the market.
Technical traders might buy a stock as the price rises on increasing volume, regardless of whether the stock is overpriced or not.
A company reporting disappointing results may be sold off as investors focused exclusively on short-term performance, pushing the share price below its underlying value.
A listed investment company (LIC) can see its share price trade below the value of the net asset value of its underlying holdings. That doesn't make much sense in theory. If you liquidated the LIC, shareholders would end up with more value than the share price.
Institutional constraints
Often, when a large company spins off a subsidiary, institutional investors will be forced to sell the shares in the spinoff, because it is too small for them to invest in, is not in the universe of stocks they are allowed to invest in, or might be excluded from their investing universe for other reasons – such as ethical reasons.
Changes to the S&P indices can also see fund managers forced to sell and buy different stocks.
Year-end tax-loss selling and portfolio window dressing can also see prices fall below their underlying value as investors put other factors ahead of value considerations.
Foolish takeaway
Seth Klarman describes value investing as a large-scale arbitrage between security prices and the underlying business value. In other words, exploiting the price differences between markets.
The above three strategies can come in useful for investors looking for an edge over the professionals and the rest of the market.
