Friday, August 29, 2014

The Benefits of a Declining Stock

I have covered on a number of occasions -- okay, maybe too many occasions -- why the long-term investor should hope that any stock they bought cheap performs poorly over the near and even intermediate term.

Well, at least if long run business prospects remain at least reasonably sound.

Over the very long haul, market prices will roughly track changes to per share intrinsic value.

Over the short haul, prices can do just about anything.

That's an advantage for the long-term investor.

Warren Buffett explained it this way in the 2011 Berkshire Hathaway (BRKa) shareholder letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

and

"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

Here's another good take on the subject from Vitaliy Katsenelson:

"A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed)."

and

"It may be painful to see your newly minted position show losses right away or remain below your purchase price for a long time. But if a company is taking advantage of its stock's cheap valuation through share repurchases, the intrinsic value of what you own is actually enhanced by the price decline."

Watching recently purchased shares drop in price right after the purchase occurred naturally doesn't exactly feel great. That's loss aversion at work and, of course, perfectly understandable. Yet it's not impossible to develop a more appropriate and sensible response. Even if an underperforming stock does not feel like such a wonderful thing, under the right circumstances and viewed rationally, it actually is.

In contrast, if an investor pays a speculative premium price on what seem like exciting future prospects that don't become reality, a drop in stock price feels pretty bad and, well, is very bad. That's likely to lead to permanent capital loss or, at least, insufficient returns considering risks and alternatives. This approach also depends heavily on being good at reliably picking winners -- usually in a dynamic and unpredictable new space where the core economics are not yet well defined -- and not paying too much for promise.

Now if, instead, the approach is to consistently pay a plain and comfortable discount to current estimated value based upon conservative assumptions, some good things seem likely to happen; big mistakes, including the likelihood of permanent capital loss, become more avoidable.

This, for example, might require judging whether a business with sound core economics and durable advantages that has long dominated an industry will continue to do so. Not exactly easy but, with enough patience and work, at least potentially less likely to produce large misjudgments and the associated losses compared to more speculative approaches.

An undervalued stock can naturally become even more undervalued but attempting to guess whether that will happen or not is folly. When I buy something, I never know what direction the price action is going to be, nor do I even try to figure that out. It's a waste of energy and leads to unnecessary mistakes (incl. errors of omission).

So temporarily lower stock prices only improve the long-term outcome if something was bought at a discount in the first place.

A long-term investor should celebrate if something they bought cheap temporarily gets even cheaper.

That's just the nature of investment even if it might go against intuition and instincts.

The tough part is becoming comfortable with thinking this way about investments. It's knowing when intrinsic value can be estimated within a narrow enough range, always paying a nice discount to that estimate, and having a truly long-term investment time horizon.

That's necessarily measured in at least many years, preferably decades or, ideally, the favorite holding period of Warren Buffett and Charlie Munger.

That'd be forever.

From the 1988 Berkshire Hathaway shareholder letter:

"...when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

So this approach doesn't work when a high price is paid and the long-term outcome is dependent on speculative assumptions.

Assumptions that, while possibly not even unreasonable, cannot be known with enough warranted confidence to invest in this manner.

When dependent on lots of difficult to foresee good things happening, it's easy to underestimate how one negative surprise can do huge damage to overall portfolio returns. A big part of investing well long-term is the elimination of large mistakes. That may not be as exciting as trying to judge what the next big thing is going to be then riding the wave, but it can offer a useful way to balance risk and reward.

What matters is whether the business at least has durable free cash flows even if it lacks exciting growth prospects. When, let's say, less than 10x durable free cash flows is paid, future share repurchases can have a big impact if the multiple at least remains roughly at that level or, ideally, goes even lower. At that kind of valuation it is durability that matters more than growth. When a plain discount to conservative per share value is paid upfront, and that discount temporarily gets even bigger, not only should it be of no concern to the long-term owner, it should be viewed as a positive development.

Of course, none of this will be of much interest to those who are primarily focused on making bets on price action.

This approach won't work very well if per share intrinsic value can't be estimated well.

This won't work if the price paid doesn't offer an appropriate margin of safety.

This won't work if time horizon is measured in only a few years or less.

Ignoring these things leads to unnecessary permanent losses and subpar results.

More in a follow-up.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
The P/E Illusion (follow-up)
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
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