Friday, August 23, 2013

Market Freezes Up

Those watching business news yesterday had to listen to talking heads acting like -- if not the end of the world -- that not being able to trade Nasdaq stocks for a few hours was yet another blow to market participant confidence.

Nasdaq market paralyzed by three hour shutdown

Well that may be the case but a marketable stock is, first and foremost, partial ownership of an operating business.

"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

So, if the market system happens to malfunction from time to time -- as it seems almost certain to do, and maybe to a much greater extent than this most recent episode -- it doesn't change the per share intrinsic value of that underlying operating business. Those with an investment time horizon were fine; traders maybe less so.
(In the flash crash certain stocks temporarily were significantly impacted. That event similarly had no impact on underlying business value. An investor who did nothing, or maybe even bought shares they liked that became a bit cheaper, was just fine.)

Now, as Charlie Munger pointed out in a conversation at Harvard-Westlake back in early 2010, there is a real benefit to knowing one can sell, relatively easily, part or all of an investment that they've made; that those risking capital become more apt to invest if they feel certain they'll generally have, when the appropriate times comes along, a straightforward, low cost, way to sell.

As Munger says: "It's not like buying a restaurant in the wrong place."

That doesn't logically mean one must be able to sell their shares every second, minute, and hour of every trading day. The beneficial aspects of this ease of conversion -- from one investment to another -- exists as long as what should be an advantage isn't turned into a disadvantage by doing lots of unnecessary trading.

Actual investment (as opposed to trading price action) just doesn't require all that much buying and selling.*

Certainly not anywhere near the amount that our hyperactive modern market system allows participants to theoretically do.

In fact, in many ways, capital formation and investment is undoubtedly negatively impacted by this hyperactivity and other forms of short-termism.

Closing a market for five years may be extremely unlikely, but it's true that a few hours should matter little to the true investor.

It's what the business does over an investment horizon that matters.

Nasdaq Flash Freeze Called 'Inexcusable'

Nasdaq OMX connectivity disaster highlights stumbling markets

Words like "inexcusable" and "disaster" may apply in some ways but, if anything, the problem seems more that we have too many market participants focused on frenetically trading in and out of marketable stocks (not to mention their derivatives). Adding layers of activity and related costs with mostly no particular enduring value added (and, as we've seen from the financial crisis, some of it plainly destructive).

It's renting price action -- what is often a zero-sum game before the frictional costs -- instead of owning pieces of businesses then benefiting from what they produce over the long haul.

Profiting from speculation on near-term price action depends upon cleverly timed trades to get good results.

In contrast, the primary drivers of investment returns come from changes to intrinsic value and the discipline to not overpay in the first place.**

An actual investment is definitely not zero sum; it depends not upon brilliant trading.

Considering the power of long run compounding effects, it seems foolish to no allow those forces to work for the investor. What initially seems like a minor tailwind becomes anything but with the benefit of longer time frames. Well, all this frenetic trading and resultant frictional costs can only, in aggregate, subtract from the magic of compounding returns.
(John Bogle calls this "the tyranny of compounding cost".)

There has certainly been lots of scientific and technological advancements that have enabled all this market hyperactivity.

James Grant once said that in science and engineering more generally (i.e. not just as it relates to finance and financial systems), progress tends to be cumulative.

Unfortunately, that's not really the case in finance.

"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind

Grant put it the following way in his latest letter:

"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Apparently, when scientific and technological progress meets financial progress, it is the latter's inherent cyclicality that wins.
(Cyclical in the sense that the same, or at least similar, mistakes seem to be repeated but the size of the financial sector as a percentage of U.S. GDP has been anything but cyclical -- especially since the 1940s.)

The systems have certainly become more sophisticated and technically complex. Whether, as a result, it's serving us better in most of the important ways seems debatable at best.

A market freeze up certainly matters for someone who has funds exposed to the market that are needed in the near term. Of course, funds needed in the near or even intermediate term shouldn't really be exposed to equities in the first place.
(Investment is ideally measured in decades, not years, but the appropriate time horizon is necessarily imprecise and unique to each situation. 2-3 years may seem long-term to some folks but, in my book, that kind of time horizon is simply not an investment horizon.)

A market disturbance like the one yesterday no doubt can pose real problems for the active trader. Yet Buffett and Munger explained back in May of this year why these sort of events should be of little concern to the long-term investor.

During such similar disturbances, the long-term investor who bought (via a marketable stock) part of a quality business at a reasonable valuation in the first place isn't hurt (again, even if the quoted price is temporarily an unpleasant one).

In fact, if it ended up being more than a short-term event, the reduced price should also not bother the long-term owner.

Why?

Well, it not only allows that owner to buy more shares cheap over time, it also allows the funds being allocated to share buybacks to go further. The highest quality businesses generally will throw off excess cash at a high return on capital. So a long-term investor focused on per share intrinsic business value should logically prefer lower stock prices in the near-term (and, for that matter, even the intermediate-term...the longer the low price persists the more powerful a buyback becomes when consistently executed below per share intrinsic value) while the business itself remains, at least, relatively sound.

Naturally an investor should want the earning power of a business to do well over the long haul but, as Warren Buffett has previously explained, a stock price that temporarily (or longer) lags is hardly a problem for the long-term investor.

Investment is about what the business itself produces over time.

Why Buffett Wants IBM's Shares "To Languish"

The intrinsic value of a productive asset (in this case a business that happens to be partially owned via a publicly traded marketable stock), especially one with durable advantages, just will not generally change nearly as much in underlying value as the daily quoted prices might otherwise suggest. There's inevitably lots of noise and, well, emotion in the short-term "votes" of a publicly traded company. A private business owner has no such noise and emotion to consider. With no daily quoted prices to distract, a long-term oriented private business owner can theoretically just focus on making sure the business is being run in a way that creates enduring value.
(Still, even with this longer term focus many businesses will do poorly or fail, of course.)

It need be no different for owners of a high quality business that happens to be publicly traded.

So these almost-certain-to-occur-from-time-to-time market disturbances matter a whole bunch for traders but not so much for investors. When justifiably confident in per share value, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.

Highly volatile, unpredictable markets (whether due to self-inflicted instability/uncertainty -- market structure, poor system design -- or an external shock) can impact the real economy if severe enough to damage business and consumer confidence.

This can also keep investors who otherwise might participate in the capital markets from doing so.

That's quite a different but potentially very real problem.

Yesterday seemed pretty mild, but I don't doubt that the more serious versions of these kind of events adversely impacts confidence. Yet a more deeply embedded -- culturally and systemically -- longer term perspective among a greater proportion of participants just might mitigate this. Some education -- the development of an alternative trained response to market fluctuations -- and the right incentives can take us a long way toward material improvement in this regard.

So both a cultural shift and systemic changes will certainly be necessary. Well, I think it's fair to say that this kind of fundamental shift is unlikely to happen fast even in the best of circumstances.

In any case, for those with a longer investment horizon, the markets should be made as welcoming as possible.

For pure near-term speculation on price action, markets should be made a less welcoming place.

That'd make for a better balance than what's currently in place.

In the meantime, a long-term investor can still do just fine if they follow sound investment principles.

Buy only what is well understood.***

Focus on underlying business value.

Always have a margin of safety.

Ignore the near-term noise.

In fact, even better yet, is allowing the inevitable market fluctuations resulting from disturbances both small -- as in what happened yesterday -- and large -- as in the financial crisis -- to work for the investor.

The right temperament goes a long way in investing.

Adam

* Charlie Munger also points out -- using Alan Greenspan as an example but there are many others, of course -- some economists are in a camp that thinks "if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization." He also adds that some "presumably are looking forward to trillions" of shares being traded and then says:

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously..."

Munger states that Alan Greenspan's view of the world when he was leading the Federal Reserve was the the result of having "overdosed on Ayn Rand." Greenspan's views may have changed since (or, maybe, directly as a result of) the financial crisis but were a real factor at the time. At the very least he has seemingly been willing to modify his world view in light of what happened. Others appear less inclined to do so.
** It's buying shares of well understood businesses, with a margin of safety, and for the most part judging correctly -- within a range -- the core long-term economics. False precision in investing just leads to trouble. Act accordingly. It's recognizing what can't be reliably known or predicted. Margin of safety can be seen as just the humble acceptance of one's own limits; the understanding that an inevitably uncertain world exists. Overconfidence in one's own ability to forecast future outcomes will likely lead to more risks taken for less reward over the long haul. When an investor always strives to pay a price that requires nothing great to happen to get a good result, there should be few complaints if things go better than expected. This requires patience, discipline, and often a fair amount of work, but eventually the market usually offers an attractive price of something that is well understood. When it does decisive action is required. Easier said than done if not impossible. When an investor protects against permanent capital loss by employing sufficient margin of safety, the good news is it then also allows unforeseen (or unforeseeable) upside to remain a possibility.
*** Naturally, whether an investment can be understood well is necessarily unique to each investor. Those who make a particular investment because someone else thinks it has attractive long-term prospects (i.e. without having come to that conclusion via their own analysis) just aren't likely to have the conviction needed to hang in there -- or, well, to not hang in there if a mistake was made -- when the price action goes the wrong way. Stick with what you know.
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