Risk and the Value Investor

The continued adherence to efficient market theory ironically makes the market less efficient. The reason: the data hungry models used to describe optimal portfolio asset allocation equate volatility with risk. The models are indifferent to whether assets are cheap or expensive in terms of current relative and absolute yields.

The obsession with this one dimensional measure of risk may actually work against the prudent man rule. In the aftermath of the 2008 credit crunch, many professional fiduciaries, as advised by their consultants, actually increased their allocation to bonds. They did this even as the benchmark 10 year Treasury Bond yielded 2.5% (a multiple of 40 times "earnings").

The value investor's view of risk differs from the conventional view. A value investors' definition of risk is permanent capital impairment. As Dr. Michael Burry puts it in Michael Lewis's book The Big Short "real risk is stupid investment decisions". Investment success always comes down to one thing: the price paid. Everything is a buy at one price and a sell at another. Risk always increases as the price goes up.

An Important Flaw of the Efficient Market Theory

"The same finance scholars who claimed that you couldn't predict future stock price movements by looking at past stock price movements were embracing the idea that future stock volatility could be predicted by looking at past stock volatility."

From The Myth of Rational Markets by Justin Fox

This theory is the cornerstone by which the consultant industry advises institutional investors. The theory, despite the above mentioned flaw in logic (and many other flaws) will be around for some time to come because 1) it provides a C.Y.A. blanket for institutional fiduciaries and 2) a lot of consultant and academic paychecks depend on it.

Lessons Learned from Seth Klarman

Seth Klarman – Lessons Learned – From a speech at Babson College 3/29/2010

Things that never happen before happen with regularity

You don't have to make every last cent on a holding

Conservative posturing prevents you from pain

Risk is relative to the price paid

Uncertainty is not risk

Never trust in risk models

Markets are driven by behavior not physical sciences

Never take risk in cash investments

Private market value is garbage

A broad and fluid investment approach is critical

It is critical to buy on the way down

It is better to be early than too late

Financial innovation is dangerous

Ratings agencies should never be trusted

Get well paid to take liquidity risk

Public investments are mostly superior to private investments because you can average down

Beware of leverage in all its forms

Match liability and asset duration because it is never safe to assume debt can be rolled over

Financial stocks are particularly risky

Having clients with long term orientations is critical

Pay no attention to government officials that say the problem is contained

The repeated follies of others is what makes the markets inefficient

Other nuggets of wisdom:

"The essence of value investing is behavioral"

"There is no money to be made in macro-economic forecasts"

"Forecasting macro-economic measures and short-term price movements is impossible. Focus what you can control which is your process and approach. Control of your process is critical."

"Don't buy from other good value investors. Buy from panicked sellers"

Long Idea - OMI

Long Idea - Owens and Minor (OMI)

OMI is one of the largest hospital supply chain businesses in the United States.

Shares of OMI are cheap due to the slowdown in the hospital business caused by high unemployment (loss of insurance coverage) and budget cuts. Many sell side analysts are modeling this as a permanent condition because management can't yet quantify when a pick-up in patient volumes might start.

The current stock price suggests that the market is under-pricing future growth potential which has at least 3 levers: 1) expansion into new markets such as ambulatory care centers 2)unemployment rates falling and/or more people gaining access to health care and 3) a continued mix shift towards high margin private label supplies.

The hospital supply market is becoming a duopoly where, on a national scale, the only other large competitor to OMI is a division of Cardinal Health. This national scale creates a competitive moat. As the trend towards consolidation of hospitals and doctor practices continues, logistics managers are looking to consolidate supply chains. OMI's scale and national footprint give the business both a scope advantage and a cost advantage that is difficult to replicate. In the latest earnings conference call, management tried to communicate this growing opportunity to analysts but they were not able to quantify the near term effect on quarterly earnings. The analysts on the call were therefore more interested in talking about things they can model into their earnings forecast such as the numbers of selling days in this quarter versus the quarter a year ago.

OMI's balance sheet is very conservative (probably too conservative) with very little debt. The company just funded the remaining pension liability and terminated the defined benefit plan. The under-levered balance sheet and steady cash flows of the business might attract private equity interest. Capital IQ gives OMI a below average rating for takeover defenses.

The main catalyst for higher share prices is a pick-up in employment that drives patient volumes back to a more normalized level. Assuming this happens sometime over the next three years (caused by on or both a drop in unemployment or some version of Obamacare actually taking effect) the company could earn $2.70+ a share. A 15 multiple, would price OMI shares at $40 giving investors a 30%+ total return including the 2.4% annual dividend.