Wednesday, May 30, 2012

Graham on Investment: "Most Intelligent When It Is Most Businesslike"

"Shares are not mere pieces of paper. They represent part-ownership of a business. So, when contemplating an investment, think like a prospective owner." - Warren Buffett

From Chapter 20 of Benjamin Graham's book The Intelligent Investor:

"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."

He then goes on to articulate what he means by "accepted business principles" and later adds...

"'If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.' (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)"

Graham closes Chapter 20 with the following thought:

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

From the Berkshire Hathaway (BRKaowner's manual:

"Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."

Among other things, the better businesses usually have, give or take, some or ideally many of the following characteristics:

- High return on capital
- Little debt (or, in the case of financials, substantial capital and liquidity)
- Easily understandable (within an investor's circle of competence)
- Accounting profits backed by healthy free cash flow
- A durable franchise with pricing power or long run cost advantages
- No need for a genius to run it
- Owner-oriented, competent, and honest managers

Consistently making sound business judgments, buying with a margin of safety, staying within one's limits, and not getting distracted by all the noise (having the right temperament) improves results.

On the other hand...

"...the exciting possibility of high near-term returns from playing the stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness." - Seth Klarman in the introduction to his book: Margin of Safety

Investors profit from the fractional ownership of underlying businesses based upon their core long run economic performance (alongside other long-term investors, of course).

No unusual trading skills required.

Minimal frictional costs.

Traders, in contrast, buy and sell shares with the intention of profiting from near term price action.
(treating shares of stocks like they are commodities to be traded.)

That's an entirely different game.

Speculators, as a whole, are playing a zero sum game. In fact, it's necessarily a negative sum when frictional costs (commissions, fees, and taxes) are included. So the most active participants incur these costs while long-term owners mostly do not.

At the current levels of hyperactivity in the markets these costs are substantial.

Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs. In aggregate, speculation adds nothing and, once all costs are considered, actually subtracts from returns.

Some individual active traders might even do just fine but, to me, the right choice in the long run for most participants seems pretty clear.

Liquidity serves a purpose but only up to a certain point.


Related posts:
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

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