Friday, March 9, 2012

Assured Mediocrity

An excerpt from the now out of print book Margin of Safety written by Seth Klarman:

If interplanetary visitors landed on Earth and examined the workings of our financial markets and the behavior of financial-market participants, they would no doubt question the intelligence of the planet's inhabitants. Wall Street, the financial marketplace where capital is allocated worldwide, is in many ways just a gigantic casino. The recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of activity than its economic utility.

 Later in the book Klarman added...

In addition, hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies designed to avoid significant underperformance at the cost of assured mediocrity.

It's certainly true that there are no shortcuts to understanding the fundamentals of a business. There's a fair amount of work and, at least in my case, a lot of time is required.*

Yet, it's also not as complicated as some may like to make it seem.

As far as investing goes, Jeremy Grantham said it very well in his latest letter:

"...if you have patience, a decent pain threshold, an ability to withstand herd mentality, perhaps one credit of college level math, and a reputation for common sense, then go for it. In my opinion, you hold enough cards and will beat most professionals (which is sadly, but realistically, a relatively modest hurdle) and may even do very well indeed."

Investors with an even temperament who know their limits and stay within them, have reasonably good business judgment, and do their homework can do just fine.

Investing well starts with learning how to value something and having the discipline and patience to buy with a substantial margin of safety.

In my view, each investor needs to develop their own models of what makes a business a good long-term investment. That's one of the reasons why I'd never buy anything based upon someone else's opinion. No one should. When an investment idea is not your own, the conviction level that's required to withstand the inevitable bumps probably won't be there.

What seems cheap often first gets even cheaper after it's been bought. That's just the moody nature of Mr. Market. Higher levels of conviction lead to a higher pain thresholds. Without that higher threshold, an investor is more likely to bail on an investment that has otherwise been judged well before reaping the benefits.

Of course, those who tend to stubbornly stay with a dumb investing idea that keeps going down in price should probably hire someone else to manage their money. Trying to "prove you are right" or stay with a poorly judged underwater investment until you "get your money back" is generally not financially fattening.

Truly thinking independently and not being tempted by what other investors are buying or selling is the key. Those that can't resist listening to the specific recommendations and opinions of others aren't likely to do well.

Some underestimate how important this is.

Assured mediocrity at best.


* I start by looking at how the business performance over the past five to ten years. For me, that historical perspective is not nearly enough. I usually need to observe the performance of business for a few years before I get comfortable with it. There are exceptions, of course. Sometimes the discount to my estimate of likely value gets large enough to warrant buying the stock sooner. Price regulates risk. When a higher quality business gets cheap enough, I'll sometimes establish a meaningful position more quickly before the chance to own it closes. Occasionally, by the time I find out I like a business the price will have become too high and the chance to buy is missed entirely. That may be annoying but it's better than losing money on something not yet well understood. If nothing else, investing this past decade taught value investors the importance of patiently waiting for a good price. There were some stocks I liked in the late 1990s that didn't get cheap until the financial crisis and, as a result, I couldn't buy until then (no kidding). So obviously I don't mind waiting for a good price. 

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