One of the most frustrating scenarios to be faced with as an investor is a stagnant stock price. You’ve done all the hard work, analysed the company correctly, invested at a deep discount to intrinsic value and waited patiently only for the stock to trend sideways for years.
In areas of the market where mispricings are most common, particularly in small-cap and micro-cap stocks, this scenario is all too common. It can take years for a stock to close the gap between the price and value — if it does at all.
Seth Klarman, the manager of the $30 billion value-focused hedge fund Baupost and the author of The Margin of Saftey, which is considered to be an updated version of Benjamin Graham’s The Intelligent Investor, thinks investors should try to avoid the above situation at all costs.
In fact, he believes “curtailing the duration (the weighted average life) of one’s portfolio” is a “key element in portfolio management.”
Curtailing portfolio duration
Writing in his 2018 letter to investors, Klarman states that investors should try to reduce portfolio duration by limiting exposure to “investments with catalysts for the realisation of underlying value” because a portfolio with a “near infinite duration (such as an all-equity portfolio without catalysts)” can trade “just about anywhere.”
He goes on to say:
“With such exposures, if stock prices plummet, the odds go up that an investor will feel pressure to do the wrong thing and sell into market weakness. A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous.”
This approach is designed to increase the “likelihood of achieving sustainable gains with limited downside risk over the long- run.”
In other words, catalysts are not required for value investing, but they can certainly help reduce the risk that you will make mistakes and potentially reduce losses.