Tuesday, June 23, 2015

Buffett: Arcane Formulae & Foolish Maxims

Warren Buffett wrote the following in his 1987 Berkshire Hathaway (BRKashareholder letter:

"...investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace."

So, as far as Buffett's concerned, it's ignoring the noise (i.e. things like macro data, what most market participants and commentators are doing/saying, etc.), controlling one's own emotional reactions, along with sound business decisions and judgments made over many years -- and, ideally, over many decades -- that has the greatest influence over investment outcomes.

It's not about attempting to correctly guess near-term price movements.

It's about increases to intrinsic business value. More from the letter:

"As Ben [Graham] said: 'In the short run, the market is a voting machine but in the long run it is a weighing machine.' The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.*

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be 'You can't go broke taking a profit.') We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business."

Back in the late 1990s, the market prices of many stocks -- and it wasn't just tech stocks -- became completely nonsensical. While prevailing prices these days aren't nearly as silly as they were back then, that doesn't mean right now is, in general, a wonderful investing environment. Far from it.**

Effective investing, best case, generally involves lots of waiting.

As stocks have rallied in recent years the risk-reward has, in fact, become much less attractive.

Time and energy is best spent understanding how to value a favored investment. Patience, discipline, and the right temperament essential. Focusing on an increased depth and breadth of understanding -- instead of the next trade -- makes it possible to act decisively with some scale when the opportunity presents itself.
(When, for example, market prices might become extreme whether on the high side or the low side.)

Meaningful discounts can arise when macro events and the headlines are most daunting and fear is running rather high. Well, at least for those businesses challenged by the immediate circumstances but otherwise with sound long-term prospects. Premium prices, possibly substantial, can arise when everything appears to be going right and it seems inevitable that such an environment will persist for some time.
(Which, of course, it won't.)

For a business with durable advantages that's comfortably financed, the risk-reward is generally most favorable when it feels like the worst time to buy. That's where being able to "insulate... thoughts and behavior" comes into play. The market price fluctuations of a quality business, over the short run, can far exceed changes to per share intrinsic value when "emotions... swirl about the marketplace."

A good business that's well understood and bought at a clear discount (to conservatively estimated per share intrinsic value) beats the best business that's not well understood bought at a healthy premium.

When an investment is truly understood ignoring the noise around you becomes, if not exactly easy, more doable. So the importance of understanding what one owns isn't just about avoiding analytical errors; it's about managing psychological factors.

During extremely adverse economic/market/financial environments, equity prices can get low enough that, even under a very bad scenario, permanent capital loss becomes extremely unlikely. Such a price may not become available often, but that's where patience comes into play.

Here's just one good example of this.

Generally, when shares of a good business are bought well in the first place, it's not a bad idea to be a reluctant seller.

Still, there inevitably will be times when it makes sense to sell.

The key thing being that it's, in fact, a good business. If future prospects change materially and permanently (and I'm not referring to the normal challenges that even the best businesses face from time to time) for the worse, or were misjudged in the first place, then patience is no longer a virtue.

Otherwise, it's when market prices represent a large premium to conservatively estimated value (within a range), or when opportunity costs are high, where selling will start to make sense.

Buying with a clear margin of safety isn't just protection against things going less well than expected; it's protection against inevitable misjudgments along with behavioral biases.

Some market participants will get caught up in the price action.

The potential for quick returns will cloud their judgment.

They start to believe it'll be possible to jump in and ride a wave until it makes sense to get out.

Well, that's not good in theory nor is it a wise strategy. Participants can mistakenly extrapolate what's been happening in recent years for far too long going into an unpredictable future. The "good times" may feel like a safer and more certain time to invest but, too often, they're just not. Existing trends that seem persistent eventually, and sometimes suddenly, prove otherwise. It's when it seems like a favorable economic environment will continue indefinitely that the risk of permanent loss is increased while return prospects are reduced.
(Due, in no small part, to the prevailing premium market prices.)

At the other end of the spectrum, some will also become less inclined to buy when market prices are most depressed. Well, it's at those times -- if one learns to ignore temporary losses and is actually good at judging value -- that the risk of permanent loss is much reduced and potential reward is greatly enhanced.***

Buying, in a disciplined way, at a discount offers real protection against uncertainty and mistakes. The price paid, unlike macro factors, is one of the few levers an investor has direct control over.

So participants may feel better during a bull market but, for those with a long time horizon, it's not an entirely sensible reaction.

The market is a servant; it's not a guide.

Risk and return can be, but need not be, positively correlated.

This, in my view, is often underappreciated and underutilized.

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier." - Howard Marks in his 'Risk Revisited' Memo

In other words, the fact that many incorrectly assume more risk must be taken to achieve greater returns doesn't make it true.

On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return.

Worth checking out.


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

Related post:

Mr. Market Revisited
Mr. Market

* Also, buybacks and dividend reinvestments are more effective when shares remain at bargain prices.
** Naturally, certain individual securities can be mispriced.
*** Unfortunately, what proves to be a temporary loss of capital versus a permanent loss is often only clear after the fact.

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