Warren Buffett wrote the following in his 1987 Berkshire Hathaway (BRKa) shareholder 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.
Adam
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.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Showing posts with label Graham. Show all posts
Showing posts with label Graham. Show all posts
Tuesday, June 23, 2015
Friday, July 18, 2014
Aesop's Investment Axiom Revisited
In this prior post, I included the following excerpt from the 2000 Berkshire Hathaway (BRKa) shareholder letter:
"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "
Aesop's Investment Axiom
Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.
"And, of course, don't literally think birds. Think dollars."
Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.
The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.
Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.
The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.
A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.
Buffett explained it the following way back in 2009:
"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."
If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.
Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.
The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.
Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.
It mostly comes down to whether enduring value is created over time.
Prices from time to time in capital markets will go to extremes.*
From an interview with Buffett:
"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."
He adds:
"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."
For the investor it's about the long run core economics of the business.
For the speculator it's the price.
It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.
Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.
Also, John Maynard Keynes once wrote:
"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."
Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)
John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.
Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.
These days, instead, stock "rental" dwarfs ownership.**
Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.
Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.
Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.
It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.
I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.
This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.
More from the 2000 Berkshire letter:
"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
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."
There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.
Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.
So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.
Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.
There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.
The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.
There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.
There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.
Come to think of it, there's plenty wrong with amount of speculation these days.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing
* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "
Aesop's Investment Axiom
Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.
"And, of course, don't literally think birds. Think dollars."
Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.
The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.
Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.
The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.
A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.
Buffett explained it the following way back in 2009:
"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."
If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.
Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.
The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.
Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.
It mostly comes down to whether enduring value is created over time.
Prices from time to time in capital markets will go to extremes.*
From an interview with Buffett:
"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."
He adds:
"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."
For the investor it's about the long run core economics of the business.
For the speculator it's the price.
It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.
Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.
Also, John Maynard Keynes once wrote:
"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."
Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)
John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.
Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.
These days, instead, stock "rental" dwarfs ownership.**
Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.
Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.
Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.
It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.
I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.
This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.
More from the 2000 Berkshire letter:
"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
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."
There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.
Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.
So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.
Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.
There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.
The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.
There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.
There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.
Come to think of it, there's plenty wrong with amount of speculation these days.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing
* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, April 7, 2014
When Mutual Funds Outperform Their Investors
From this MarketWatch article:
"...the typical investor booked a 4.8% annualized gain over the last decade, while the typical fund gained an average of 7.3% a year.
The same article goes on to point out the following based upon research by Morningstar:
"...investors do a good job of picking mutual funds, but a poor job in timing their moves between asset classes."
Russel Kinnel of Morningstar explained, as one recent example, that, in terms of fund flows, mutual fund investors "were going in all the wrong directions entering 2013."
Basically, they were buying mutual funds that allocate capital into bonds and selling those that are focused on U.S. stocks.* They did this at a time when doing roughly the opposite (or nothing at all) would likely have served them better. This is not an argument to get the timing right; this is an argument to not try to time such things in the first place.
This Barron's article from last month added the following:
"Individual investors have long been accused of being a lagging indicator, pouring money into areas of the market after they've seen their biggest run-ups. But that's a mistake not limited to just retail investors, but also often made by pensions and endowments managing much larger pools of money, according to insiders."
One of the major reasons for the underperformance is "that few investors sit tight in a fund" along with, once again, poorly executed attempts at timing the market.
"...the gap in returns is exacerbated by big pivot years for the market, when investors appear to have especially bad timing."
The Barron's article also notes that investors were mostly getting out of equities in 2009 while moving assets into things like bonds and commodities. Once again, not exactly the best time to be doing such things even if it probably felt like the right thing to do. The equity markets have, give or take, roughly doubled -- even if the investor didn't buy at the most opportune moments that year -- since 2009. With no doubt good intentions, investors too often do just about the opposite of what would improve returns. Influenced too much by what they've experienced recently -- what's in the rear-view mirror -- they tend to take actions that are detrimental even though, at the time, it might have felt like the right thing to do.
Benjamin Graham: Timing vs Pricing Stocks
Investors are just too often their own worst enemies. There's just no need to pick market bottoms nor is it really possible to do so consistently well. More generally, it's just not wise to make big timing calls a central aspect of the process.
"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett
The focus needs to be, or should be, on how price compares to well-judged per share intrinsic value.
Now, sometimes the right time to buy might happen to coincide with the right price, but price versus value should still be the emphasis. Good things are just more likely to happen in the long run -- even if far from a certainty -- when always buying at a plain discount to value is a central principle. There's nearly no doubt that price action might get ugly -- at the very least from time to time -- in the near and intermediate term. Expect it and, well, learn mostly ignore it. If all buying is truly at a discount to value, the price action in the early years should become increasingly irrelevant over the long haul.** Timing will inevitably end up being off; what is truly cheap becomes even cheaper due to psychological and other factors (the same, of course, can be true in the opposite direction). Yet it's easy to forget the risk of NOT owning something understandable that's become sensibly priced (in the context of long-term investment) due to fears it will temporarily get even cheaper.
In other words, attempts to get both pricing and timing right invites errors that need not be made by those who have a long-term investment horizon.
The reality is that getting the price versus value judgment right is hard enough to do consistently well without adding timing to the equation.
So it's learning to ignore price action, judging the value of what's understandable frequently well, then developing the patience and discipline to buy when there's a discount.
The most attractive discounts usually prevail when a recent or ongoing economic storm -- and the associated painful losses -- dominate the psychology of those involved.
Participants who buy when the outlook is rosy aren't likely to get great long-term results. Ditto for those who tend to sell when the outlook feels uncertain and, well, maybe even a bit scary.
In fact, the opposite behavior has a much better likelihood of being rewarded.
None of the above is necessarily easy to do well. Then again, it's also hardly impossible with the right level of energy and focus in combination with an real awareness of abilities and limits.
Overconfidence destroys results.
It's worth highlighting that, as the Barron's article notes, it's not like the investment pros -- what some might consider the "smart money" -- aren't susceptible to making the same kind of mistakes as the non-professionals.
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers
In other words, we might be looking at a more generalized element of human nature that, to be successful, must be tamed by the market participant no matter what the level of knowledge and expertise happens to be.
Adam
Related posts:
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Apparently, investors were also buying lots of emerging markets funds at a rather inopportune time.
** In fact, prices that remain persistently at a discount can benefit the long-term investor, and it's not just because it allows that investor to accumulate more shares; it's because the company can use excess capital to do the same.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...the typical investor booked a 4.8% annualized gain over the last decade, while the typical fund gained an average of 7.3% a year.
The same article goes on to point out the following based upon research by Morningstar:
"...investors do a good job of picking mutual funds, but a poor job in timing their moves between asset classes."
Russel Kinnel of Morningstar explained, as one recent example, that, in terms of fund flows, mutual fund investors "were going in all the wrong directions entering 2013."
Basically, they were buying mutual funds that allocate capital into bonds and selling those that are focused on U.S. stocks.* They did this at a time when doing roughly the opposite (or nothing at all) would likely have served them better. This is not an argument to get the timing right; this is an argument to not try to time such things in the first place.
This Barron's article from last month added the following:
"Individual investors have long been accused of being a lagging indicator, pouring money into areas of the market after they've seen their biggest run-ups. But that's a mistake not limited to just retail investors, but also often made by pensions and endowments managing much larger pools of money, according to insiders."
One of the major reasons for the underperformance is "that few investors sit tight in a fund" along with, once again, poorly executed attempts at timing the market.
"...the gap in returns is exacerbated by big pivot years for the market, when investors appear to have especially bad timing."
The Barron's article also notes that investors were mostly getting out of equities in 2009 while moving assets into things like bonds and commodities. Once again, not exactly the best time to be doing such things even if it probably felt like the right thing to do. The equity markets have, give or take, roughly doubled -- even if the investor didn't buy at the most opportune moments that year -- since 2009. With no doubt good intentions, investors too often do just about the opposite of what would improve returns. Influenced too much by what they've experienced recently -- what's in the rear-view mirror -- they tend to take actions that are detrimental even though, at the time, it might have felt like the right thing to do.
Benjamin Graham: Timing vs Pricing Stocks
Investors are just too often their own worst enemies. There's just no need to pick market bottoms nor is it really possible to do so consistently well. More generally, it's just not wise to make big timing calls a central aspect of the process.
"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett
Now, sometimes the right time to buy might happen to coincide with the right price, but price versus value should still be the emphasis. Good things are just more likely to happen in the long run -- even if far from a certainty -- when always buying at a plain discount to value is a central principle. There's nearly no doubt that price action might get ugly -- at the very least from time to time -- in the near and intermediate term. Expect it and, well, learn mostly ignore it. If all buying is truly at a discount to value, the price action in the early years should become increasingly irrelevant over the long haul.** Timing will inevitably end up being off; what is truly cheap becomes even cheaper due to psychological and other factors (the same, of course, can be true in the opposite direction). Yet it's easy to forget the risk of NOT owning something understandable that's become sensibly priced (in the context of long-term investment) due to fears it will temporarily get even cheaper.
In other words, attempts to get both pricing and timing right invites errors that need not be made by those who have a long-term investment horizon.
The reality is that getting the price versus value judgment right is hard enough to do consistently well without adding timing to the equation.
So it's learning to ignore price action, judging the value of what's understandable frequently well, then developing the patience and discipline to buy when there's a discount.
The most attractive discounts usually prevail when a recent or ongoing economic storm -- and the associated painful losses -- dominate the psychology of those involved.
Participants who buy when the outlook is rosy aren't likely to get great long-term results. Ditto for those who tend to sell when the outlook feels uncertain and, well, maybe even a bit scary.
In fact, the opposite behavior has a much better likelihood of being rewarded.
None of the above is necessarily easy to do well. Then again, it's also hardly impossible with the right level of energy and focus in combination with an real awareness of abilities and limits.
Overconfidence destroys results.
It's worth highlighting that, as the Barron's article notes, it's not like the investment pros -- what some might consider the "smart money" -- aren't susceptible to making the same kind of mistakes as the non-professionals.
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers
In other words, we might be looking at a more generalized element of human nature that, to be successful, must be tamed by the market participant no matter what the level of knowledge and expertise happens to be.
Adam
Related posts:
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Apparently, investors were also buying lots of emerging markets funds at a rather inopportune time.
** In fact, prices that remain persistently at a discount can benefit the long-term investor, and it's not just because it allows that investor to accumulate more shares; it's because the company can use excess capital to do the same.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, March 1, 2013
Benjamin Graham: Timing vs Pricing Stocks
From Chapter 8 of The Intelligent Investor:
"By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.
We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's* financial results." - Benjamin Graham
Back in 2009, Warren Buffett said the following:
"We don't try to pick bottoms. To sit around and not do something sensible because you think there might be something better…. doesn't make sense. Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett
Buffett: Picking bottoms is impossible
Market participants attempting to get the timing right (something that seems more close to futile than not) end up distracted from what's important: Making price versus valuation judgments that, over the long haul, will get the best possible result at the least risk.
Attempts at timing is inherently speculative and a distraction away from the all-important price versus value discipline.
Mispriced assets often seem to get sorted out in nearly, if not completely, unpredictable ways in terms of timing. It's important to be realistic -- when the timing does happen to work out -- about the real reasons why. Successful moves don't always get the scrutiny they deserve.
Sometimes the favorable outcome was more about luck than great foresight.
Sometimes it has little to do with having some unusual talent for predicting the amount and timing of price movements.
Not knowing when a favorable outcome was mostly accidental is a recipe for future mistakes.
An approach dependent on lucky or accidental outcomes is destined to result in even bigger losses down the road if it leads to unwarranted overconfidence. A few successful outcomes resulting more from good fortune, less on real foresight, might encourage that market participant to put even larger amounts of capital at risk (with maybe less favorable outcomes). I'm not saying no one can effectively time these things (even though my interest in such an approach is effectively zero). I'm saying those that try had better have a realistic view of their own abilities.
Overestimation of one's own talent in this regard will likely end up being very expensive.
The good news is a long-term investor doesn't have to get the timing right if sound price versus value judgments are mostly being made. Mistakes are inevitable, of course. The key is keeping them small and infrequent. One way to keep them small and infrequent is to always pay an appropriate discount to a well-judged valuation. An appropriate margin of safety is protection against small misjudgments (since valuation even done well is inherently imprecise) and the unforeseen adverse developments that inevitably arise in an unpredictable world.
Developing competence when it comes to understanding how price relates to the value of an asset is a good use of energy.
Attempts at timing the market generally isn't.
Expect wild fluctuations in price and allow that inevitable dynamic -- Mr. Market's inherent moodiness and -- to serve.
Adam
* Earlier in Chapter 8 Graham writes: "If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end..."
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.
We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's* financial results." - Benjamin Graham
Back in 2009, Warren Buffett said the following:
"We don't try to pick bottoms. To sit around and not do something sensible because you think there might be something better…. doesn't make sense. Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett
Buffett: Picking bottoms is impossible
Market participants attempting to get the timing right (something that seems more close to futile than not) end up distracted from what's important: Making price versus valuation judgments that, over the long haul, will get the best possible result at the least risk.
Attempts at timing is inherently speculative and a distraction away from the all-important price versus value discipline.
Mispriced assets often seem to get sorted out in nearly, if not completely, unpredictable ways in terms of timing. It's important to be realistic -- when the timing does happen to work out -- about the real reasons why. Successful moves don't always get the scrutiny they deserve.
Sometimes the favorable outcome was more about luck than great foresight.
Sometimes it has little to do with having some unusual talent for predicting the amount and timing of price movements.
Not knowing when a favorable outcome was mostly accidental is a recipe for future mistakes.
An approach dependent on lucky or accidental outcomes is destined to result in even bigger losses down the road if it leads to unwarranted overconfidence. A few successful outcomes resulting more from good fortune, less on real foresight, might encourage that market participant to put even larger amounts of capital at risk (with maybe less favorable outcomes). I'm not saying no one can effectively time these things (even though my interest in such an approach is effectively zero). I'm saying those that try had better have a realistic view of their own abilities.
Overestimation of one's own talent in this regard will likely end up being very expensive.
The good news is a long-term investor doesn't have to get the timing right if sound price versus value judgments are mostly being made. Mistakes are inevitable, of course. The key is keeping them small and infrequent. One way to keep them small and infrequent is to always pay an appropriate discount to a well-judged valuation. An appropriate margin of safety is protection against small misjudgments (since valuation even done well is inherently imprecise) and the unforeseen adverse developments that inevitably arise in an unpredictable world.
Developing competence when it comes to understanding how price relates to the value of an asset is a good use of energy.
Attempts at timing the market generally isn't.
Expect wild fluctuations in price and allow that inevitable dynamic -- Mr. Market's inherent moodiness and -- to serve.
Adam
* Earlier in Chapter 8 Graham writes: "If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end..."
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...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.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Monday, September 17, 2012
Klarman & Graham: The Margin of Safety Principle
From the introduction section of Seth Klarman's book Margin of Safety:
"If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time.
Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites."
In rising markets, it's the favored stocks that have captured the imagination of active participants that tend to do better than what, at least in the near term, might be out of favor (cheap or otherwise). In the book Seth Klarman points out that those with a value focus tend to sell "too soon" as equities, in general, go from becoming fully valued to just being plain overvalued.
I'd add that, for similar reasons, a value approach also often leads to buying and selling "too soon".*
More from Margin of Safety:
"The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.
Those who can predict the future should participate fully...when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments."
Some might be tempted to adjust investing styles and strategies to the environment.
In other words, in addition to a value focus, why not try to learn how to predict the direction of price action of a particular security or for the market as a whole?
Why suffer the consequences of selling or buying too early, right?
Well, best of luck with that.
Maybe more than a few can actually predict the future direction of the market effectively. Yet consider me skeptical that a methodology, whatever it might be, can be applied by a large number of market participants in a way that reliably produces above average results.
It just doesn't seem very likely this can be done reliably well. My guess is the result would be costly mistakes leading to sub-par returns over the long haul for most who try.
At a minimum, identifying examples of those that can reliably foresee the future direction of the market, and have a proven track record, isn't easy.
(I suspect this won't deter those who seem to try!)
By comparison, finding examples of capable value investors with proven long-term track records is rather easy.
There's plenty of evidence that any number of variations of disciplined value investing can produce attractive long-term results. The primary driver of returns is intrinsic business value and how it changes over time and no real need to know what direction the market might be headed near term. The market is simply there to serve the investor.
Value investing only works over the long haul if securities are purchased with an appropriate margin of safety (even if in the short run price action implies otherwise) and value is consistently well-judged. The benefits of a well-executed value approach is particularly significant when viewed through a risk-adjusted prism.
One serious mistake that gets made is as follows: projecting forward the earnings a business has produced under recent favorable economic conditions. In other words, not enough consideration of what they'll look like under much less than optimal conditions. The end result ends up being an insufficient margin of safety. For all but the highest quality businesses earnings needs to be normalized over at least a full business cycle.
For some lower quality businesses -- particularly those that are capital intensive, highly cyclical, and in fiercely competitive industries -- a full business cycle may not even enough.
Benjamin Graham had the following to say in Chapter 20 of The Intelligent Investor.**
"...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."
Earning power under favorable business conditions is usually insufficient. It is especially the case for the lower quality variety of enterprise. Understanding how earning power might vary over a full business cycle (again, and sometimes even longer) matters a bunch.
As does balance sheet strength. Weaker franchises require the most balance sheet flexibility.
The higher quality enterprises (and I'm generally NOT talking about fast-growers or highly dynamic industries), those that sometimes even seem just a little expensive, will often suffer rather modest drops in earnings during periods of severely unfavorable business conditions.
Judging their normalized earning power, and how it may increase over the long haul, is more straightforward than most.
The benefits of their relative earnings persistence shouldn't be underestimated but frequently is.
The lower quality enterprises, those that may even appear cheap but in reality are anything but, will sometimes see near catastrophic drops in earnings capacity during severely unfavorable business conditions.
Judging their normalized earning power is far from straightforward.
For these, it is more likely that a substantial misjudgment by the investor will end up being made. So, inevitably, they demand a much larger margin of safety and, more often than not, they should just be avoided due to the wide range of possible outcomes.
The most vulnerable businesses, especially those that don't prepare operationally and financially for the next severe drop in economic activity, will leave common equity shareholders wondering what happened to what once appeared to be a nice margin of safety.
Adam
* It seems not exactly surprising those with a value focus (and less interested in playing near-term price action) would be early sellers and buyers. There are many reasons why what's cheap just gets cheaper and vice versa in the near-term and, yes, sometimes for a bit longer. It seems inevitable that those who invest primarily with value in mind will, at times, act too early in either situation. If something is plainly cheap accumulation has to begin at some point and it's likely not at the eventual lowest price. Yet selling and buying early is anything but a big problem long-term if you're mostly getting business value right and clearly paying a nice discount. Only if the investing time horizon is short is it a real issue. So it's learning to not be annoyed by, or pay much attention to, near term price action. Not always easy. It's a necessary trained response considering how much loss aversion can impact investing behavior. I mean, a value focus should lead logically to the hope that what is cheap does get even cheaper in the near or even intermediate term. This is especially true during the share accumulation process but not limited to it. A stock that gets cheaper -- and I've covered this many times -- also allows the benefits per dollar spent on a buyback to be even more potent for long-term owners. The important thing is, of course, that shares are actually selling below intrinsic value. So if value has been judged generally well, then a temporarily lower stock price is a very good thing. Learning to manage the innate influence of loss aversion is probably the toughest part for most. Attempts to buy at the lowest price creates its own problems. One being possibly owning few shares (or no shares) when an investor wants to own a meaningful amount (a partial or complete error of omission). What if the stock happens to unexpectedly reverse course? Some may not consider this but it is a real risk. Maybe the window of opportunity closes, maybe it doesn't. What's worse, staring at temporary paper losses for some time, or permanently missing the chance to own a meaningful amount of something for the long-haul? When highly confident that an attractive long-term investment is selling plainly below what it's worth, it's important to buy it in some quantity when the chance is there. It's difficult enough to find something one understands and wants to own for the long haul. Why worry about some near term price fluctuations in those cases?
** Margin of safety is the principle focus of Chapter 20.
Intro. 12
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time.
Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites."
In rising markets, it's the favored stocks that have captured the imagination of active participants that tend to do better than what, at least in the near term, might be out of favor (cheap or otherwise). In the book Seth Klarman points out that those with a value focus tend to sell "too soon" as equities, in general, go from becoming fully valued to just being plain overvalued.
I'd add that, for similar reasons, a value approach also often leads to buying and selling "too soon".*
More from Margin of Safety:
"The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.
Those who can predict the future should participate fully...when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments."
Some might be tempted to adjust investing styles and strategies to the environment.
In other words, in addition to a value focus, why not try to learn how to predict the direction of price action of a particular security or for the market as a whole?
Why suffer the consequences of selling or buying too early, right?
Well, best of luck with that.
Maybe more than a few can actually predict the future direction of the market effectively. Yet consider me skeptical that a methodology, whatever it might be, can be applied by a large number of market participants in a way that reliably produces above average results.
It just doesn't seem very likely this can be done reliably well. My guess is the result would be costly mistakes leading to sub-par returns over the long haul for most who try.
At a minimum, identifying examples of those that can reliably foresee the future direction of the market, and have a proven track record, isn't easy.
(I suspect this won't deter those who seem to try!)
By comparison, finding examples of capable value investors with proven long-term track records is rather easy.
There's plenty of evidence that any number of variations of disciplined value investing can produce attractive long-term results. The primary driver of returns is intrinsic business value and how it changes over time and no real need to know what direction the market might be headed near term. The market is simply there to serve the investor.
Value investing only works over the long haul if securities are purchased with an appropriate margin of safety (even if in the short run price action implies otherwise) and value is consistently well-judged. The benefits of a well-executed value approach is particularly significant when viewed through a risk-adjusted prism.
One serious mistake that gets made is as follows: projecting forward the earnings a business has produced under recent favorable economic conditions. In other words, not enough consideration of what they'll look like under much less than optimal conditions. The end result ends up being an insufficient margin of safety. For all but the highest quality businesses earnings needs to be normalized over at least a full business cycle.
For some lower quality businesses -- particularly those that are capital intensive, highly cyclical, and in fiercely competitive industries -- a full business cycle may not even enough.
Benjamin Graham had the following to say in Chapter 20 of The Intelligent Investor.**
"...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."
Earning power under favorable business conditions is usually insufficient. It is especially the case for the lower quality variety of enterprise. Understanding how earning power might vary over a full business cycle (again, and sometimes even longer) matters a bunch.
As does balance sheet strength. Weaker franchises require the most balance sheet flexibility.
The higher quality enterprises (and I'm generally NOT talking about fast-growers or highly dynamic industries), those that sometimes even seem just a little expensive, will often suffer rather modest drops in earnings during periods of severely unfavorable business conditions.
Judging their normalized earning power, and how it may increase over the long haul, is more straightforward than most.
The benefits of their relative earnings persistence shouldn't be underestimated but frequently is.
The lower quality enterprises, those that may even appear cheap but in reality are anything but, will sometimes see near catastrophic drops in earnings capacity during severely unfavorable business conditions.
Judging their normalized earning power is far from straightforward.
For these, it is more likely that a substantial misjudgment by the investor will end up being made. So, inevitably, they demand a much larger margin of safety and, more often than not, they should just be avoided due to the wide range of possible outcomes.
The most vulnerable businesses, especially those that don't prepare operationally and financially for the next severe drop in economic activity, will leave common equity shareholders wondering what happened to what once appeared to be a nice margin of safety.
Adam
* It seems not exactly surprising those with a value focus (and less interested in playing near-term price action) would be early sellers and buyers. There are many reasons why what's cheap just gets cheaper and vice versa in the near-term and, yes, sometimes for a bit longer. It seems inevitable that those who invest primarily with value in mind will, at times, act too early in either situation. If something is plainly cheap accumulation has to begin at some point and it's likely not at the eventual lowest price. Yet selling and buying early is anything but a big problem long-term if you're mostly getting business value right and clearly paying a nice discount. Only if the investing time horizon is short is it a real issue. So it's learning to not be annoyed by, or pay much attention to, near term price action. Not always easy. It's a necessary trained response considering how much loss aversion can impact investing behavior. I mean, a value focus should lead logically to the hope that what is cheap does get even cheaper in the near or even intermediate term. This is especially true during the share accumulation process but not limited to it. A stock that gets cheaper -- and I've covered this many times -- also allows the benefits per dollar spent on a buyback to be even more potent for long-term owners. The important thing is, of course, that shares are actually selling below intrinsic value. So if value has been judged generally well, then a temporarily lower stock price is a very good thing. Learning to manage the innate influence of loss aversion is probably the toughest part for most. Attempts to buy at the lowest price creates its own problems. One being possibly owning few shares (or no shares) when an investor wants to own a meaningful amount (a partial or complete error of omission). What if the stock happens to unexpectedly reverse course? Some may not consider this but it is a real risk. Maybe the window of opportunity closes, maybe it doesn't. What's worse, staring at temporary paper losses for some time, or permanently missing the chance to own a meaningful amount of something for the long-haul? When highly confident that an attractive long-term investment is selling plainly below what it's worth, it's important to buy it in some quantity when the chance is there. It's difficult enough to find something one understands and wants to own for the long haul. Why worry about some near term price fluctuations in those cases?
** Margin of safety is the principle focus of Chapter 20.
Intro. 12
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, May 30, 2012
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
"Shares are not mere pieces of paper. They represent part-ownership of a business. So, when contemplating an investment, think like a prospective owner." - Warren Buffett
From Chapter 20 of Benjamin Graham's book The Intelligent Investor:
"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."
He then goes on to articulate what he means by "accepted business principles" and later adds...
"'If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.' (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)"
Graham closes Chapter 20 with the following thought:
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."
From the Berkshire Hathaway (BRKa) owner's manual:
"Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."
Among other things, the better businesses usually have, give or take, some or ideally many of the following characteristics:
- High return on capital
- Little debt (or, in the case of financials, substantial capital and liquidity)
- Easily understandable (within an investor's circle of competence)
- Accounting profits backed by healthy free cash flow
- A durable franchise with pricing power or long run cost advantages
- No need for a genius to run it
- Owner-oriented, competent, and honest managers
Consistently making sound business judgments, buying with a margin of safety, staying within one's limits, and not getting distracted by all the noise (having the right temperament) improves results.
On the other hand...
"...the exciting possibility of high near-term returns from playing the stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness." - Seth Klarman in the introduction to his book: Margin of Safety
Investors profit from the fractional ownership of underlying businesses based upon their core long run economic performance (alongside other long-term investors, of course).
No unusual trading skills required.
Minimal frictional costs.
Traders, in contrast, buy and sell shares with the intention of profiting from near term price action.
(treating shares of stocks like they are commodities to be traded.)
That's an entirely different game.
Speculators, as a whole, are playing a zero sum game. In fact, it's necessarily a negative sum when frictional costs (commissions, fees, and taxes) are included. So the most active participants incur these costs while long-term owners mostly do not.
At the current levels of hyperactivity in the markets these costs are substantial.
Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs. In aggregate, speculation adds nothing and, once all costs are considered, actually subtracts from returns.
Some individual active traders might even do just fine but, to me, the right choice in the long run for most participants seems pretty clear.
Liquidity serves a purpose but only up to a certain point.
Adam
Related posts:
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Intro. 11
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
From Chapter 20 of Benjamin Graham's book The Intelligent Investor:
"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."
He then goes on to articulate what he means by "accepted business principles" and later adds...
"'If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.' (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)"
Graham closes Chapter 20 with the following thought:
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."
From the Berkshire Hathaway (BRKa) owner's manual:
"Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."
Among other things, the better businesses usually have, give or take, some or ideally many of the following characteristics:
- High return on capital
- Little debt (or, in the case of financials, substantial capital and liquidity)
- Easily understandable (within an investor's circle of competence)
- Accounting profits backed by healthy free cash flow
- A durable franchise with pricing power or long run cost advantages
- No need for a genius to run it
- Owner-oriented, competent, and honest managers
Consistently making sound business judgments, buying with a margin of safety, staying within one's limits, and not getting distracted by all the noise (having the right temperament) improves results.
On the other hand...
"...the exciting possibility of high near-term returns from playing the stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness." - Seth Klarman in the introduction to his book: Margin of Safety
Investors profit from the fractional ownership of underlying businesses based upon their core long run economic performance (alongside other long-term investors, of course).
No unusual trading skills required.
Minimal frictional costs.
Traders, in contrast, buy and sell shares with the intention of profiting from near term price action.
(treating shares of stocks like they are commodities to be traded.)
That's an entirely different game.
Speculators, as a whole, are playing a zero sum game. In fact, it's necessarily a negative sum when frictional costs (commissions, fees, and taxes) are included. So the most active participants incur these costs while long-term owners mostly do not.
At the current levels of hyperactivity in the markets these costs are substantial.
Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs. In aggregate, speculation adds nothing and, once all costs are considered, actually subtracts from returns.
Some individual active traders might even do just fine but, to me, the right choice in the long run for most participants seems pretty clear.
Liquidity serves a purpose but only up to a certain point.
Adam
Related posts:
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Intro. 11
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, March 29, 2012
Benjamin Graham: Margin of Safety
From Chapter 20 of Ben Graham's book, The Intelligent Investor:
"...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."
Graham, later in the same chapter, added the following:
"...it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity."
Highly cyclical, capital intensive businesses that have what seems like manageable debt can be far riskier than they seem when a healthy economy turns south.
They'll seem cheap in the good times but those with highly variable revenues, lots of fixed costs (operating leverage), and debt (financial leverage) are sometimes deceptively expensive.
What seems like normalized earnings in an expanding economy (and especially a bubble) turn out to be far from robust in a less favorable economic environment. Lower quality businesses end up struggling to cover interest charges and often can't lower their fixed operating expenses fast enough if the recession is severe enough.
Even if current owners don't get wiped out, a business that requires capital when it's scarce and common equity prices are low isn't the best thing to own.
One benefit of the recent financial crisis for investors is that it is easy to study which businesses had the toughest time during that period of severely reduced business activity.
It may not have been anything close to the worst economic conditions that could occur but was still a pretty good test.
The bottom line is that under favorable economic conditions some lower quality businesses have a margin of safety in appearance only.
The fact that a premium to intrinsic value was actually paid may not become obvious until it's too late.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"...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."
Graham, later in the same chapter, added the following:
"...it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity."
Highly cyclical, capital intensive businesses that have what seems like manageable debt can be far riskier than they seem when a healthy economy turns south.
They'll seem cheap in the good times but those with highly variable revenues, lots of fixed costs (operating leverage), and debt (financial leverage) are sometimes deceptively expensive.
What seems like normalized earnings in an expanding economy (and especially a bubble) turn out to be far from robust in a less favorable economic environment. Lower quality businesses end up struggling to cover interest charges and often can't lower their fixed operating expenses fast enough if the recession is severe enough.
Even if current owners don't get wiped out, a business that requires capital when it's scarce and common equity prices are low isn't the best thing to own.
One benefit of the recent financial crisis for investors is that it is easy to study which businesses had the toughest time during that period of severely reduced business activity.
It may not have been anything close to the worst economic conditions that could occur but was still a pretty good test.
The bottom line is that under favorable economic conditions some lower quality businesses have a margin of safety in appearance only.
The fact that a premium to intrinsic value was actually paid may not become obvious until it's too late.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Thursday, March 15, 2012
Ben Graham: Better Than Average Expected Growth
From Chapter 8 of The Intelligent Investor by Benjamin Graham:
A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.
Shares of businesses with exciting growth prospects (and usually a great story) often sell at a substantial premium to their current value.
There's always exceptions, of course, but pay for promise not yet realized and watch out below if things don't go quite as well as hoped.
Businesses with big growth opportunities attract competition* and wider range of future outcomes.
In contrast, it's usually not difficult to find publicly traded shares of a business with sound economics if unexciting growth prospects (and likely an even less exciting story) selling at an attractive price relative to current value. If shares are bought at or near the right price, satisfactory or better returns can be achieved even if nothing particularly good happens to the business.
Now, a bit of stable growth from a business with durable competitive advantages is certainly nice. It's just that getting in the habit of paying a premium for potential opens the door to an unacceptably high probability of permanent capital loss.
Graham later in the chapter added that an investor...
...can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.
Being detached from market price action is a lot easier when shares of an enterprise are primarily owned for long run profit-producing capacity.
I'm guessing many get this at some level though it seems less practice it.
It's certainly not due to a lack of IQ. There's no shortage of informed and intelligent market participants.
Sir Isaac Newton made the case for this as well as anyone with his participation in the folly of the South Sea Bubble.
His genius did nothing to prevent him from being totally wiped out by it.
Adam
Related posts:
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* The tobacco industry comes to mind. Who'd want to take on the established players in the U.S. cigarette market?
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.
Shares of businesses with exciting growth prospects (and usually a great story) often sell at a substantial premium to their current value.
There's always exceptions, of course, but pay for promise not yet realized and watch out below if things don't go quite as well as hoped.
Businesses with big growth opportunities attract competition* and wider range of future outcomes.
In contrast, it's usually not difficult to find publicly traded shares of a business with sound economics if unexciting growth prospects (and likely an even less exciting story) selling at an attractive price relative to current value. If shares are bought at or near the right price, satisfactory or better returns can be achieved even if nothing particularly good happens to the business.
Now, a bit of stable growth from a business with durable competitive advantages is certainly nice. It's just that getting in the habit of paying a premium for potential opens the door to an unacceptably high probability of permanent capital loss.
Graham later in the chapter added that an investor...
...can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.
Being detached from market price action is a lot easier when shares of an enterprise are primarily owned for long run profit-producing capacity.
I'm guessing many get this at some level though it seems less practice it.
It's certainly not due to a lack of IQ. There's no shortage of informed and intelligent market participants.
Sir Isaac Newton made the case for this as well as anyone with his participation in the folly of the South Sea Bubble.
His genius did nothing to prevent him from being totally wiped out by it.
Adam
Related posts:
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
* The tobacco industry comes to mind. Who'd want to take on the established players in the U.S. cigarette market?
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, July 22, 2011
Buffett on Speculation and Investment - Part II
A follow up to this post:
Buffett on Speculation and Investment
"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." - Benjamin Graham in The Intelligent Investor
Speculators generally focus on price action in the near term.
For investors, it's mostly not about price action, it's about what the asset can produce in the long run relative to what was paid for the asset.
What the price does next week, month, or even much longer matters little.
Speculators take on risk and enable other participants manage/transfer risk. It can be a very useful and beneficial role. Yet, in the markets, the proportion of activity that is pure speculating versus investing matters.
It's not difficult to show that, in many systems, more of what is initially a useful thing creates diminishing returns or worse.
The following may help to illustrate the point.
It's certainly no perfect analogy but consider a petrol engine. It happens to operate best when the stoichiometric air-fuel ratio is very near 14.7 to 1 (mass ratio of air to fuel present during combustion). Get much above or below that ratio and the engine performs poorly (or not at all). In other words, it's not like more fuel is always better. Eventually too much fuel destroys performance.
So there is a narrow operating range around that ratio for the engine to perform its best. For a petrol engine, the air-fuel ratio for optimum performance happens to hover around 14.7 to 1.
Of course, I'm not suggesting that specific ratio -- or any precise ratio -- applies to capital markets. With too much air a petrol engine simply won't run. That's not necessarily the case for capital markets. Clearly, any system involving lots of temperamental human participants could never have such precision. So just because it's not working optimally doesn't mean it won't work at all. Still, I think it's fair to say the market has developed in ways that are way beyond being even in the ballpark of an optimal ratio of speculators (i.e. the air) in proportion to the investment-oriented participants (i.e. the fuel).
The equivalent to an "air-fuel" ratio for the markets has, in my view, become more than just a bit out of balance in recent years. The relatively small amount of actual investing compared to substantial speculation, and in some cases pure gambling, is making the market engine run a bit lean.*
The assumption that more is better, even when it's something initially beneficial, is where I think a mistake is being made. There's this prevailing belief that if some initially beneficial added market liquidity is good then anything short of an infinite amount more of it must be better. I think it is wise to be a bit skeptical of this.
"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting
Buffett makes a further distinction between speculation and gambling that I'll address in a follow-up.
Adam
Related posts:
Buffett on Gambling and Speculation (follow-up)
Buffett on Speculation and Investment
* Running either rich (too much fuel) or lean (too little fuel) means lost performance in an engine.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Buffett on Speculation and Investment
"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." - Benjamin Graham in The Intelligent Investor
Speculators generally focus on price action in the near term.
For investors, it's mostly not about price action, it's about what the asset can produce in the long run relative to what was paid for the asset.
What the price does next week, month, or even much longer matters little.
Speculators take on risk and enable other participants manage/transfer risk. It can be a very useful and beneficial role. Yet, in the markets, the proportion of activity that is pure speculating versus investing matters.
It's not difficult to show that, in many systems, more of what is initially a useful thing creates diminishing returns or worse.
The following may help to illustrate the point.
It's certainly no perfect analogy but consider a petrol engine. It happens to operate best when the stoichiometric air-fuel ratio is very near 14.7 to 1 (mass ratio of air to fuel present during combustion). Get much above or below that ratio and the engine performs poorly (or not at all). In other words, it's not like more fuel is always better. Eventually too much fuel destroys performance.
So there is a narrow operating range around that ratio for the engine to perform its best. For a petrol engine, the air-fuel ratio for optimum performance happens to hover around 14.7 to 1.
Of course, I'm not suggesting that specific ratio -- or any precise ratio -- applies to capital markets. With too much air a petrol engine simply won't run. That's not necessarily the case for capital markets. Clearly, any system involving lots of temperamental human participants could never have such precision. So just because it's not working optimally doesn't mean it won't work at all. Still, I think it's fair to say the market has developed in ways that are way beyond being even in the ballpark of an optimal ratio of speculators (i.e. the air) in proportion to the investment-oriented participants (i.e. the fuel).
The equivalent to an "air-fuel" ratio for the markets has, in my view, become more than just a bit out of balance in recent years. The relatively small amount of actual investing compared to substantial speculation, and in some cases pure gambling, is making the market engine run a bit lean.*
The assumption that more is better, even when it's something initially beneficial, is where I think a mistake is being made. There's this prevailing belief that if some initially beneficial added market liquidity is good then anything short of an infinite amount more of it must be better. I think it is wise to be a bit skeptical of this.
"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting
Buffett makes a further distinction between speculation and gambling that I'll address in a follow-up.
Adam
Related posts:
Buffett on Gambling and Speculation (follow-up)
Buffett on Speculation and Investment
* Running either rich (too much fuel) or lean (too little fuel) means lost performance in an engine.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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