Wednesday, February 6, 2013

Margin of Safety & Mr. Market's Mood

It was not difficult at all to buy stocks cheap (some higher quality, some less so) not too long ago when the Mr. Market's mood was more nervous and, at times, even extremely fearful. Well, in the context of the current environment, consider the following quotes by Ben Graham, Warren Buffett, Seth Klarman, Charlie Munger, and Peter Lynch:

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to 'earning power' and assume that prosperity is synonymous with safety." - Benjamin Graham in Chapter 20 of his book The Intelligent Investor

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money." - Warren Buffett in the 2000 Berkshire Hathaway Shareholder Letter

"...investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others..." - Seth Klarman in his book Margin of Safety

"The idea of a margin of safety, a [Ben] Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas." - Charlie Munger at the 2003 Wesco Annual Meeting

"When the neighbors tell me what to buy, and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble." - Peter Lynch on the fourth and last stage of his "cocktail party" theory*

Three or four years ago the higher quality businesses -- those that tend to have the most durable core economics -- became if not cheap, at least cheap enough. Still, they did not drop nearly as much as the lower quality variety during the financial crisis. Buying the lower quality stuff at the height of the crisis may have worked out very well but many of them carried greater risk of permanent capital loss. In other words, after the fact it is easy to see it worked out okay, but the risks of capital loss was very real if the crisis had become even worse.

"Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it's the lack of change that appeals to me. I don't think it is going to be hurt by the Internet. That's the kind of business I like." - Warren Buffett in Businessweek

Three or four years ago, nice discounts weren't hard to find for the best businesses -- those that Buffett describes as "profiting from lack of change" -- even if some of the lower quality businesses turned out to offer, in some cases, the possibility for huge gains (and, in some cases, maybe big losses).

Well, the situation is now a very different one.

These days, shares of high quality businesses are becoming increasingly difficult to buy with sufficient margin of safety. That, of course, doesn't necessarily mean we're anywhere near the "stage four" that Peter Lynch describes above. It doesn't mean the market won't continue going up. It's just that even the best need to be bought in a way that accounts for the fact that, as Klarman says:

"...valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes."

Rising prices can start drawing investors in because it feels safer. Yet bargains often become increasingly difficult to come by when the market mood improves. There's a greater likelihood of permanent capital loss when increasingly high prices are paid. My primary interest lies in estimating value as well as is possible within my own limitations -- which as Klarman points out is necessarily imprecise -- then only putting capital at risk only when something I understand can be bought with a significant margin of safety.**

So as market prices rise the investing environment becomes increasingly a challenge.

Even if it happens to feel safer, investing, by definition, becomes more difficult and risks are increased as prices climb. If prices do go higher from here it's worth remembering the last sentence in the first of the two above quotes by Warren Buffett:

"Nothing sedates rationality like large doses of effortless money." 

Now, this doesn't mean I'd sell shares of an attractive business, bought at a great price, just because market prices begin to fully reflect intrinsic value.

That's a recipe for unnecessary mistakes and frictional costs.

There's only so many businesses that most investors can understand sufficiently well. Jumping out of something well understood (and bought well) that is temporarily fully valued, or even slightly more than fully valued, but otherwise has attractive long run prospects is just inviting expensive mistakes.***

Once I own enough shares of a good business at a discount to value, then my preference is to just own it for a very long time. That means occasional continued ownership of a good business during periods when it is not particularly cheap (though per share intrinsic value should continue to increase, even if unevenly, over time). Some might attempt to jump out of the stock with the intent to somehow get back in at just the right time.

It's the illusion of control.

There's plenty of evidence to suggest this approach is mostly a good idea in theory only. I'll let others try to pull off that sort of thing.

Sometimes the tide is with you, sometimes it is not.

"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?" - Charlie Munger interview at the University of Michigan

Charlie Munger: Snare and a Delusion

Learning to judge price versus value effectively, and having the discipline to buy only when selling at a plain discount, seems far more doable (even if far from easy). Consistently make wise judgments on something as complex as macroeconomic cycles seems, at least to me, near impossible. The good news is investing well doesn't really require significant macroeconomic insights.

Adam

* From Lynch's book One Up On Wall Street.
** An investor should always come up with their own valuation/required margin of safety. In other words, never buy a marketable stock based upon what someone else thinks. What's one good reason for this among many? Well, without an in depth feel for what something is really worth, the conviction required for an investor to "hang tough" just won't be there when market price inevitably goes the wrong way. A temporarily reduced price is generally not a problem if intrinsic value has been judged well. It is a problem if the investor ends up selling low out of fear/lack of conviction. This, of course, requires an ability to value the shares of businesses consistently well and a real awareness of limitations.

That's why I think that no investor should be buying a stock that someone else happens to like no matter how good the track record of that investor happens to be. What might make sense for one investor likely does not for another.
*** Including, after taxation, the possibility of not being able to buy a piece of an attractive business cheap again for a very long time. There are times, of course, that selling makes lots of sense. Some examples of circumstances where selling becomes a logical consideration:
- if the economic moat of a business becomes materially damaged;
- if value was judged poorly in the first place (error of commission);
- if an investment becomes plainly very expensive (not just somewhat);
- if a position has become an uncomfortably large part of the portfolio;
- if the opportunity costs of continued ownership are very high.
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