In 2005, Seth Klarman of Baupost Capital warned a group of Wharton business school students that a new class of "value pretenders" had emerged. Klarman, whose fund has earned more than 20% annual returns on more than $5 billion in holdings, provided the following description: "These investors apply a dip strategy. They buy what's down, not what's cheap." Expanding that definition to include investors who simply copy value-investing gurus, here are a couple of things Fools can do to avoid being value pretenders.
Are you a value pretender?
We've all done it before. We buy a stock simply because we read that [insert value investing guru here] bought it. It's not the biggest sin in the world to simply piggyback the great investors, but it's not the ideal strategy, either.
Of course, investors could've made some great returns piggybacking on Warren Buffett's purchase of oil giant PetroChina (NYSE: PTR ) or Eddie Lampert's investment in auto-parts retailer AutoZone (NYSE: AZO ) . However, there's a lot more to investing than copying the greats.
Don't get me wrong. There's nothing wrong with taking a glance at Mohnish Pabrai's or Seth Klarman's SEC filings; it'd be dumb to entirely ignore what successful investors are doing. However, investors need to ask themselves some brutally honest questions: If you found out that Klarman sold this stock tomorrow, would you still want to buy it? If so, why?
Do your own homework
Merely imitating the great investors might make you money, but it won't teach you anything. Investors who simply copied Baupost's idea to buy shares of student loan originator SLM (NYSE: SLM ) would've seen their fortunes soar when private equity firm JC Flowers made a bid for the company. Unfortunately, those copycats probably wouldn't understand why Baupost bought Sallie Mae, or what the firm's price target was.
It now appears that Baupost thought Sallie Mae had reached its intrinsic value during the summer; it sold most of its stake between June 30 and Sept. 30, when shares were between $50 and $60 per share. However, Baupost didn't have to file an SEC report that it had sold most of its stake until Nov. 13. By then, shares had fallen to around $40 per share. They're now trading around $20, partly because JC Flowers ultimately walked away from the deal.
Is the stock down or cheap?
The skill that separates great poker players from the pretenders is the ability to lay down the second-best hand. Most poker players will bet big when they make a great hand -- and lose everything if it's only the second-best at the table. Only the great poker players can consistently fold seemingly great hands when they sense that someone else has an even better hand.
Similarly, great value investors have to avoid stocks that look cheap but are doomed to get even cheaper, and identify the stocks that are truly cheap from a value perspective.
Online broker E*Trade (Nasdaq: ETFC ) , mortgage lender Countrywide Financial (NYSE: CFC ) , and homebuilder Beazer (NYSE: BZH ) are just a few of the stocks that probably looked cheap when they got cut in half earlier this year. Unfortunately, all of these stocks got cut in half again, as more credit problems surfaced. Simply buying on the initial dips for these companies would've been disastrous.
One small step for man ...
It's not the end of the world if you realize that you've been following a value-pretending strategy. The first step is to be aware of it and start to remedy it by improving your research process and learning to develop investing ideas independent of whatever the value-investing gurus are doing. Who knows? Maybe someday, value pretenders will be copying your moves.