Marks turned me onto this sort of thinking, and I have never, ever looked back. Great thought piece here!

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You are so correct in noting the any price phenomenon. Many are over compensating for past errors of not slightly paying up. Like Munger said, “ investing is hard”. Great article.

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Great stuff Aaron. A few things that come to mind, wondering your thoughts on this.

1. Given the already difficult long feedback loop of investing, how much more difficult is a strategy like this to judge, where you can chalk things up as “it’s still in the underperforming stage”, as opposed to knowing you made a mistake in your analysis? Investing in a business that’s supposed to do well is quite easy to know when you’re wrong, if the business consistently is not doing well, safe to say you made a mistake. But with this strategy, underperforming is all par for the course.

2. Do you find there are many instances in which the fundamental degradation is even worse than what’s already priced in, thus eating into your MOS?

3. Does this extend to all types of underperformers, or just ones who are having “company specific” underperformance? For example, does this extend to businesses facing secular decline?

Thanks for sharing.

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Hi Larson, all great questions and happy to answer them:

1. The answer to this can be found in George Soros' quote, "It's not whether you're right or wrong that's important, but how much money you make when you're right and lose when you're wrong". The essence of this strategy revolves around managing uncertainty using Margin of Safety. So rather than trying to forecast future outcomes with pinpoint precision, we are admittedly leaving business outcomes open-ended to an extent. But not investment outcomes, because at least you have already addressed the worst-case scenario by "not losing money even if you're wrong".

I know it's not the best answer, but it's still better than pretending that we can forecast future outcomes with 100% certainty otherwise. Just think about how stock prices have fluctuated over the past 3 years. "Better to be generally accurate than precisely wrong."

2. Generally no, if you've done your homework. Take $INTC today for instance. To the best of my ability to estimate, the reasonable worst-case scenario is a normalized 7.5x PE based on historical earnings performance multiple years in a row. It is difficult to see how $INTC's valuation stays persistently below current levels over future cyclical improvements over the LT, even if its business fundamentals continues to worsen. I think most people would agree that even an ex-growth $INTC can deserve a 10x PE amidst a cyclical recovery. The idea is to focus on investment downside exposure, and the question to business downside exposure will take care of itself.

3. I think the correct framing to provide context to my answer here is that I only call them "Underperformers" because that's what they tend to look like on the surface. Underperformance is not what such stocks are defined by, but rather their adherence to Margin of Safety by virtue of their undervaluation. However it is when stocks look like Underperformers that the greatest dislocations between price and value appear, i.e. greatest Margin of Safety. As such, whether they are underperforming due to idiosyncratic or systemic reasons is not really a key criteria for a stock to qualify as an Underperformer. What matters much more is whether there is a sufficient Margin of Safety built into its valuation.

Theoretically, even if a business is facing secular decline, it still has a fundamental value of "x" - and if you can acquire it at half of "x" with zero estimable downside in all reasonable future scenarios, then yes it would qualify. Of course, whether such opportunities are frequently available in a practical sense is a different question. Underperformers is used to describe the investment principle rather than specific examples.

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Dec 2, 2023·edited Dec 2, 2023Liked by Aaron Pek

Hi Larson,

regarding your first question I would say you've rightly highlighted the difficulty in distinguishing between an underperforming asset and an analytical mistake. In value investing, understanding the fine line between a temporary underperformance and a fundamental error is crucial. It demands a thorough analysis of the business fundamentals and the ability to discern between short-term hiccups and deeper structural issues. Howard Marks' "Mastering the Market Cycle" brilliantly addresses this, emphasizing the importance of differentiating between the two.

I would highly recommend it to you.



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Great advice, second it

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I think another way to differentiate between cigar butts and Underperformers is to describe it like this:

- the cigar butts approach is about rooting around in the rubbish bin and looking for something which isn't absolute garbage.

- the Underperformers approach is about rooting around in the rubbish bin and looking for the occasional gem which had been accidentally thrown away.

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