Jeremy Grantham's 1Q 2011 Letter

From part 2 of Jeremy Grantham's 1st Quarter 2011 letter:

Time To Be Serious (and probably too early) Once Again

"...if you are a value manager, you buy cheap assets. If you are very 'experienced,' a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink."

Oddly inexpensive, clearly mispriced assets, (a dollar bill selling for 50 cents) often get a whole lot cheaper. It's almost a given.

Short-to-intermediate-term forces in the markets will often take what seems an extreme value already to an even further extreme.

Ultimately, favorable long-term returns will still be produced if price versus a conservative estimate of value is correctly assessed. Still, seeing some red ink on paper inevitably happens to even experienced value-oriented investors.

The idea is to pay a large discount for something that temporarily has low expectations.  If things go a bit better than expected you end up making a nice return over the long-run. If things don't get better, or even deteriorate, you don't lose much if anything because of the extremely low price paid.

That's very different from misjudging the value of something and holding on while real losses mount. Trying to get you money back if you've made a misjudgment in what something is actually worth is never wise.

Investors often try to do this and returns suffer greatly and unnecessarily as a result.

If the quoted price remains in the red, even if for an extended period, but intrinsic value was judged correctly...no big deal.

Again, as long as the stock was purchased at a clear discount to a conservative estimate of that value.

In that situation, a long-term investor can either just ignore the near term price fluctuations or buy more of the mispriced asset at an even bigger discount.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

Investing is never about the short or even intermediate term price action. It's about the price paid relative to the value today and, more importantly, how the value of that asset will increase intrinsically over time.

It's the long run earning power of a productive asset.

Unfortunately, for almost all businesses it's impossible to know with any precision how the future will turn out. So less certainty obviously means a greater discount or margin of safety is needed.

Consider Coca-Cola (KO), a not particularly inexpensive stock these days but certainly among the highest quality businesses. It has excellent core economics and many durable competitive advantages. These high quality characteristics justify a smaller margin of safety than most.

25 years ago, Coca-Cola was selling for ~$ 5 bucks a share. It is now on the verge of producing nearly $ 4/share in earnings each year and that stream of earnings continues to grow. Today, the dividend alone is $ 1.88/share so in a little over every 2.5 years an investor in Coca-Cola back then now receives cash dividends equal to the price paid. How the stock of a quality business trades several years after it was bought is irrelevant to the long-term investor. With great businesses time is indeed your ally.

 So while even Coca-Cola's future is impossible to know with any certainty the next 25 years hardly looks unattractive.

Long-term investors are always dealing with balancing the risk of seeing some red ink on the computer screen for an extended period with making sure enough of a desirable asset is owned. It's no fun ending up with the quantity of "an eyedropper" when a full eight ounce glass was wanted.

So seeing some quotes in the red for a period of time goes with the territory.

The question is: if you are not selling anytime soon who cares if there's a temporary paper loss when you expect something to compound in value materially in a decade or so?
(and if it's a quality business continuing to increase in value well beyond that over time)

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett at the 2009 Berkshire Hathaway (BRKa) Shareholder Meeting

The bottom line is buying "too early" is going to happen but things work out okay if you get the price versus value right.

Adam

Long position in KO and BRKb

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