Friday, March 29, 2013

Buy the Business, Not the Stock

Here's what Warren Buffett had to say about the group of investors he highlighted in the Superinvestors of Graham-and-Doddsville:

"I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It's very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.

I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical."

Some thoughts:

- The idea that more risk must be taken to achieve greater returns seems persistent to this day. Well, Warren Buffett more than just suggested that the opposite might be true in this article nearly 30 years ago.

It's fine to disagree with something after serious examination, but this way of thinking about risk and return seems to have been effectively ignored by many. When something successful flies in the face of conventional wisdom or, at least, a prevailing model, it deserves to at least be carefully considered before choosing to discard or ignore it.
(Also, it's not like the idea is from some random unproven source.)

- This idea of "buying the business, not buying the stock" is hardly a new insight, but it's worth emphasizing in an era where the average holding period of stocks is either at or near all-time lows. A very short average holding period may not prove fewer market participants than ever are primarily thinking about "buying the business". Yet, when the length of time many stocks are being held can be measured in months, weeks, minutes, or even less, it's not likely that thinking like a business owner is front and center for those participants.

Naturally, many market participants are well aware of and understand this way of thinking, but quite a few must not value it or think it unimportant. The successful value-oriented investors doesn't just think that buying pieces of a business is one and the same with buying the whole business, they act accordingly. The group of investors highlighted by Buffett in the article certainly thought and behaved in a way that's consistent with a buy the business ethos.

Those own a business outright generally won't sell it at the first sign of trouble with the hope of jumping back in if and when the trouble wanes. Well, those that own a small pieces of a business can choose to think and behave in the same manner.

The fact is even the best businesses gets into some difficulties from time to time and, considering the relative liquidity of stock markets, it's obviously tempting to just sell and move onto something else.

It certainly is more convenient and costs less than ever to trade hyperactively. So it's understandable that many market participants are tempted to take full advantage of this reality.

That doesn't make it wise.

Of course, inevitably, misjudgments are made and a stock must be sold; inevitably, better use for the capital arises; inevitably, a stock gets extremely expensive and warrants selling.

Still, that doesn't mean the value-oriented stock market participant can't choose to think like the buyer of a business as a core part of their investment process.

- Quite a few seem convinced that the market remains quite efficient even if, as Donald Yacktman points out, shares of a relatively large businesses tend to fluctuate roughly 50% over a 12-month period.

Well, intrinsic value just doesn't move around that much.

"Shares of a relatively big company will fluctuate probably 50% from low to high in a 12-month period. That encourages a lot of short-term trading, and yet short-term traders tend not to do very well over time." - Donald Yacktman

Whether buying an entire business or part, the long run results will still mostly come down to having some patience, the right temperament, an ability to judge business economics, then paying an appropriate price.

Well that and, of course, the integrity and competence of management.

Taking some time to read (or re-read) The Superinvestors of Graham-and-Doddsville in its entirety is at least as useful now as it was nearly 3 decades ago.


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