Lecture 1 for Lesson 1, Readings: Margin of Safety and Mr. Market from The Intelligent Investor, Preface from the book, Deep Value by Tobias Carlisle, and Behavioral Portfolio Management.
Supplementary readings: Quantitative Value, Margin of Safety (Klarman) Value Investing (Montier) and for special projects. --
Thanks for those who sent their answers. Your replies help me assess who is in the class. We have almost 500 students enrolled and many seem knowledgeable and astute. If you request something or ask a question and I don’t respond, please place in block letters in an email to
[email protected], SECOND REQUEST. Typically, I respond within 24 hours, but I receive hundreds of emails, so don’t take it personally if I am slow to respond or your email request is lost.
Let’s sit down and discuss why I sent you these readings.
All intelligent investing is value investing—acquiring more than you are paying for. You must value the business in order to value the stock. –Charlie Munger.
I think of investing as trying to buy bargains typically when other investors feel, need, or must sell urgently. If we are correct in our assessment of intrinsic value, (“IV”)-defined through future discounted cash flows or private market value between two cogent investors--then Regression to the Mean should work over a reasonable time to close the gap between the price we paid and IV. Note that Graham NEVER discussed how to calculate intrinsic value. Valuation is subject to judgment and it is
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often a range of values depending upon our assumptions and cost of capital. Often we can’t value a company because of our lack of expertise. The market provides a place where prices are offered or bid on securities (bonds/stocks) of underlying businesses. Since we are prone to error as are all other investors we build in a Margin of Safety by waiting for a large enough discount in the price paid, by using conservative assumptions, diversification, and by staying within our circle of competence. Margin of safety is central to the attitude of a deep value investor. We also should be aware of who is on the other side of the trade from us. If the price of a company’s stock is dropping while insiders are selling heavily, we had best reconsider our assumptions.
So here is our dilemma. We as Deep Value Investors (“DVIs”) seek to identify measurable and persistent behavioral price distortions and then capitalize on those distortions. In other words, when people go crazy, we seek to take advantage. But people over-react, go crazy, fear loss, seek out certainty, and herd together because they are human, but so are we. What makes us so special? Won’t we fall prey to those same biases? We will explore this further in the course.
What is Value Investing? If you asked John Neff, Peter Lynch, Ben Graham, Seth Klarman, and Charlie Munger they might say basically the same thing, buying a business for less than its worth, but their portfolios might all be different. We will be focusing on Deep Value stocks. These are losing stocks that become asymmetric opportunities with limited downside and enormous upside. Yes, but aren’t we trading off big upside with big risk? If we factor in the risk of loss then are we really obtaining a bargain? What about value traps where value erodes as fast as price? The key for us to focus on in this course will this dilemma. Deep value stocks may have a higher risk of bankruptcy individually, but as a group, the risk is OVERCOMPENSATED. In other words, we are highly compensated for taking the other side of the distressed selling. Is that statement true? If investors over-react due to various biases like recency bias, loss aversion, myopia, etc. AND the process
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of Mean Reversion works, then can we profit on a risk-adjusted basis? At the end of this course, we should be able to answer that question. Any one of our investments may go to $0.00 (What did Buffett say, “Rule 1: Don’t lose money and never forget rule 1.” Out of 20 mispriced opportunities, we may have three go to zero, two or three drop 50% and stay there, but 14 rise and provide us with a decent return.
Investme nt
Result
$1.00
$0.00 OUCH!
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$0.00 OUCH!
$1.00
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$0.50 Help!
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$0.50 Help!
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$1.20
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$1.00
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$24.4 5
22.50 %
My goals for students are:
You (and I) are the enemy thus we need to build protections against our flaws. Investing often goes against the grain of how our brains evolved. See the grass rustle, a tiger lurks. Don’t think about it—RUN! See the plunging price of my stock, sell! We are hardwired to react QUICKLY to danger or else we wouldn’t be here (our ancestors wouldn’t have passed on their genes). Recognized that we are as flawed,
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fearful, hopeful, and subject to emotion as others. We must figure out a way to work around our natural instincts. Buffett and Graham spoke of temperament and character being more important than IQ. So how will we develop such character? We will try in this course.
Practice thinking independently (Be skeptical/prove it to yourself). This will take courage and solitude. If you are not comfortable sitting alone in a room reading and thinking, then investing for yourself may not be the best use of your time. That’s OK; you must find a path for yourself. Don’t waste time seeking out gurus for advice. Mr. Market is there to serve you not guide you. Can you imagine walking into a grocery store/food market and asking the vendor how much you should buy and at what price? No. Good. Wall Street or the “Market” can’t tell you what you should do. Wall Street is there to generate fees and commissions while raising capital for businesses and transacting trades. Two timeless books on Wall Street are Where Are the Customers’ Yachts or A Good Hard Look at Wall Street by Fred Schwed, Jr. and the Money Game by “Adam Smith” (Jerry Goodman). Finally, Reminiscences of a Stock Operator by Edwin Lefevre is a classic on the psychology of traders, investors, and brokers. I suggest an annual rereading of these classics to calm the nerves. Since human nature hasn’t changed, people tend to react similarly. Or, as a Wall Street veteran remarked, “The music never changes, just the players.”
Try to read original source documents rather than a second-hand source. Read a company’s 10-K rather than a brokerage report’s buy recommendation. We will be reading several of the research reports that the author of DEEP VALUE read to write his book.
Investing is most successful when most businesslike. Students need to treat their investing like a business. You should know your philosophy, methodology, and strengths/weaknesses of your approach while being meticulous in recording/tracking your investments/progress. How will you learn from your successes and mistakes?
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For example, since deep value investing may be highly counter-cyclical to the general market, you may widely “underperform” a benchmark index for a long period of time. The patience required is difficult and uncertainty is often confused with risk.
Risk is meaningless without a preceding adjective. Risk is not volatility (unless you are heavily leveraged). Risk could be: operational, political, management, or financial risk. Or the risk could be YOU—your emotional state, your hubris, and/or undisciplined actions.
Students should realize that investing is simple but not easy. Prof. Joel Greenblatt in his MBA class and his book, The Little Book that Beats the Market (to be emailed later) says that all he does is figure out what a business is worth and then pay a whole lot less for it. Seems simple but how to go from here to there? Prof. Greenblatt also says he is not better at analyzing companies than many Wall Street analysts but he knows what he knows (his circle of competence) and he weights mispriced bets. When he often can’t value a company, he moves on. Investing is something you do (or not do until you do decide to act). As an investor always consider who is on the other side of the trade from you so you don’t become the patsy or fool at the poker table. A fool ceases to be a fool when he or she quits/corrects the mistake. The deep value investor is seeking out mispriced securities however that is determined.
Many readers say their goal is to become better at determining intrinsic value (“IV”) because then they would have the knowledge and confidence to buy and sell when prices move away from IV. HOWEVER….
My bias is that it is NOT difficult to find price below value when there is extreme panic or distress on the part of sellers, but the difficulty lies in ACTING to seize the opportunity. Even DEEP VALUE investors are human with all the same biases as others. When the company’s stock is plummeting, analysts are downgrading their Lecture
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earnings estimates, the news for the industry’s future is terrible, and then perhaps, we fear, the value we see isn’t there. Our fears overcome us. We will wait until we gain more certainty—we practice REARVIEW investing. We become part of the same herd that will act emotionally to provide us with mispricing. Walking across a plank isn’t hard, but when that plank is perched between two cliffs 1,000 feet above the ground, then the difficulty increases. Noise overwhelms the signal; our fears stop us from acting.
If knowledge was all we needed then why are there so many fat (obese) Americans when 100s of diet books are published each year. How can we close the yawning gap between knowing and doing?
The video of the crash landing in the Hudson should teach you the importance of remaining rational/calm while following a process. The pilot went through his checklist of seeking an alternative airport and he remained focused in flying the plane to the water. Was he lucky? He had tremendous flying skill, but the weather was clear so he was fortunate in that respect. Never forget the importance of randomness/luck. I think with practice one can train oneself to be calm/rational in stressful situations. Studying past market cycles/financial history and understanding the industries and the financial characteristics of businesses should help you in developing realistic assumptions. Also, developing confidence in regression to the mean will steady you. Always allow for being in error.
Behavioral Portfolio Management (The Next Paradigm) shows how one money manager, C. Thomas Howard build a method to protect himself from behavioral errors. A reader mentions:
I have a splinter in my mind.
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In regards to the poker video, a better scene would have been if Teddy made a bet not getting the right pot odds implied or otherwise.
For example, if the board was 6-7-k and Matt had 8-9 he would have an open end straight draw. He would make straight with one of four 10s or four 5s. 8 outs total. With two cards to come he has about 32% chance of making a straight or about 1:3. If he is getting 10:1 on his $ he's got to go for it. 1:1 he has to fold.
Teddy, on the other hand, has to create a situation that would put Matt in a position for him to chose to make a bad bet. Like making it so expensive for him to draw; putting 70% of his chips to gain only 30% in the pot.
When people either don't know the odds or know the odds and don't follow them due to emotion, both lead to poor long term results.
Questions from the readings: Do you agree that deep value investing is an investment triumph disguised as business
disaster? Yes although it’s a difficult concept to grasp and implement. What do you see as the biggest investment risk(s) in “deep value investing?” Misjudging the intrinsic value of a business. As Klarman say: “make sure 1 dollar is worth 1 dollar”. When do stocks appear most attractive and when is the risk highest? They are most attractive when margin of safety is sufficient. Risk is highest when there is no margin of safety. What is considered the main margin of safety metric?
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Price/intrinsic value. What are investors rewarded for? Spotting mispriced securities. What concept must you truly grasp to be a successful deep value investor? Margin of Safety. Why do prices move more than intrinsic value? Human psychology, namely fear and greed. True or False: A good value investor understands and takes advantage of the behavioral
biases of others because he has already eliminated them in him/herself? True. Deep value investing often means buying distressed assets but can you buy a franchise
(see attachment of Wal-Mart or a company able to grow with profits above its cost of capital due to barriers to entry) at deep value prices? Name two investments by Buffett that might fit that criteria? WMT_50 Year SRC Chart Coca-Cola Sanofi How can we think of activist investing? Activist help reveal mispricing by spotting ever misallocated capital, restructuring potential or mispriced assets (cash, other assets). What are your goals for this course? Becoming a better investor, especially regarding the determination of intrinsic value. How do Mr. Graham and Mr. Buffett view buying a share of stock?
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It’s a piece of a business. What do you do if you can’t find an attractive investment? Keep cash available to take advantage of market volatility. What is Mr. Market’s purpose? Naming prices How are prices set? in Philadelphia it’s worth fifty Bucks (video) Cash is king. The seller is desperate for cash. The buyer has no rush to buy. Are prices based on subjective or objective valuation? Subjective valuation. If you are playing poker and you don’t know who the sucker is—why is that a problem?
Who’s the sucker? Playing the sucker (video) Malkovitch.
WhatEMOTIONAL error did the SUCKER display? Overconfidence.
When did the sucker CEASE to be a sucker? No idea. When he realized he had the wrong process?
What is the main error–man, especially male, beginning investors—exhibit? Considering the market is a “weighing machine” while it’s a “voting machine”. What is the key to investment success? Spotting mispriced securities.
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What TYPE of market participant seeks Mr. Market for investment guidance? Do you
notice any conflicts, ironies or problems? Or can it be a way to improve your investment results? Speculators seek Mr. Market for investment guidance. How do many investors react to huge market volatility? They sell when prices fall, and buy when they rise. Did Mr. Graham give you a way to access the valuation of a common stock? Explain. Extra credit: Did Graham ever give a FORMULA for determining intrinsic value? Be
careful and read the footnotes to the formula he presents and why he offers it to readers. See Intelligent Investor. For the 2 previous questions: rather than a formula, in my opinion, Graham gave more an investment guidance: assess the earnings power of a stock (earnings yield for instance) and compare it to a more secure securities (bond of high quality companies). What is the biggest mistake investors make when buying securities? How would you
prevent that? What does Graham do? They don’t forge their own view of the value of a stock and they don’t buy with a margin of safety. What is the danger in growth stock investing? Not paying attention to the quality of the stock and considering past growth as a trend for future forecasting. What is a good or bad stock/investment? A good investment usually displays a comfortable margin of safety that protects from estimation error. When during the past fifty years were the greatest American companies (Franchises mostly)
bad investments. Why? During the Nifty Fifty period, when the market priced an infinite blue sky scenario for stocks that already traded at steep valuation multiples.
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What is the best approach to take in investing. Ignore the market; know the value of things and wait for market to offer sufficient discount to intrinsic value to buy with a margin of safety. What is risk? The permanent loss of capital, not volatility. Why do so many “smart” people fail at investing or at least do less well than simple stock
indexes over time? They let their emotions dominate their investment process.
You can email me at
[email protected] with LESSON 1 in the title with questions and answers or post here in the comments section. If you don’t have time or wish to pass then come back to this lesson later. What are the five investment criteria in the Behavioral Portfolio Management? What is the cult of emotion? Is it possible for emotion to help you as an investor?
I will be asking for one or two volunteers who wish to research the article BEHAVIORAL PORTFOLIO MANAGEMENT. You will need to read the articles below and then determine if the author’s five criteria will work. Over this course, I will probably assign twenty or so special projects. Then we will share your work/efforts.
_____________________________________ Jocelyn Jovène
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Do you agree that deep value investing is an investment triumph disguised as business disaster?
Agreed but with a major caveat.
Deep Value relies on 2 aspects. First is the possible involvement of activist investors to enter at distressed earnings and improve the poor management and lead to a change and second is the natural law of reversion to mean even without the presence of activist investor. Since the cause of depressed earnings can be operational (which can be improved when an activist investor with a good past record of turning around companies enters the company or even threatens to over throw the existing management) or environmental ( in case the company is going through tailwinds and the price has fallen way below what earnings justify), it provides an investor a tremendous amount of safety in purchase of such depressed entities.
Caveat One: Activism is not prevalent in all the countries and one has to be very cautious of following this strategy in all type of countries. The judiciary, regulatory and legal structure of the countries has to support the activism is order for this to be a model to rely on. Being from a country like India and knowing few people who have attempted in past, its far more difficult to practice it here so most of the ‘Deep Value’ theme companies can end being a value trap since majority equity is held by promoters who can keep the barbarians away from the gate using means which are, strictly speaking, not legal or moral.
What do you see as the biggest investment risk(s) in “deep value
investing?”
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Concentration of portfolio in select few deep value stocks. It has to be diversified enough if the involvement is limited to taking small minority stakes and not actually becoming the agent of change. Diversification also takes care of the errors of judgment and gaps in industry understanding and worse than average luck
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Lack of near ‘permanent capital’: Investing in deep value needs patience because the actual turnaround time is near impossible to predict. If one depends on the capital that is invested, one may find it difficult to make profitable investments from Deep Value investing.
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Not selling at an appropriate time (Appropriate time is very difficult for me to describe here in words. But as a general rule, if it crosses the higher estimate of your intrinsic value range calculation, you should sell. Its more individualistic a decision than any) Since the question only asked for Investment risks, I am ignoring the psychological factors in the answer
When do stocks appear most attractive and when is the risk highest?
Temporary Tailwinds or blood on the street usually leaves stocks much cheaper and attractive. Inactivity on macro front also tires up investors and lead to irrational selling. On the other hand when the best case scenarios (earnings in the peak cycle of business) are considered as norm and discounted in prices, to enter then is the riskiest proposition.
What is considered the main margin of safety metric?
Difference between the earning yield and the bond yield
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What are investors rewarded for?
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For being right and different.
What concept must you truly grasp to be a successful deep value
investor?
Concept of ‘Margin of Safety’
Why do prices move more than intrinsic value?
The perceptions of reality changes and the motivations of buying and selling is not always related to intrinsic value leading to supply demand equation different from one justified by intrinsic value
True or False: A good value investor understands and takes advantage of the
behavioral biases of others because he has already eliminated them in him/herself?
False: They are not eliminated. Just handled better.
Deep value investing often means buying distressed assets but can you buy a
franchise (see attachment of Wal-Mart or a company able to grow with profits above its cost of capital due to barriers to entry) at deep value prices? Name two investments by Buffett that might fit that criteria? WMT_50 Year SRC Chart
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American Express and Salomon Brothers as per me How can we think of activist investing?
As I said earlier, Operating in a country like India, Activism is risky and a deep pocket play but for a individual small investor, he can bring the companies to notice and seek to benefit from involvement of activist investors. Either be the change; drive the change or at-least bringing it to notice of someone who can.
What are your goals for this course?
Revise, re-learn few things, un-learn some crap I may have gotten in my head in these years and looking from fresh perspective again.
How do Mr. Graham and Mr. Buffett view buying a share of stock?
Buying a part of business as an investment and not a speculation What do you do if you can’t find an attractive investment?
Sit and wait. What’s the hurry ? But in my experience, there is always an attractive investment. It may not be a long term investment and more event based special situations one when overall market is not throwing any other opportunities.
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What is Mr. Market’s purpose?
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To serve an investor.
How are prices set? in Philadelphia it’s worth fifty Bucks (video)
Demand and Supply equation based on perceptions of reality of the market participants
Are prices based on subjective or objective valuation?
Subjective: On the basis of perceptions that drives the so called objective valuations based on excel sheet calculations (physics envy)
If you are playing poker and you don’t know who the sucker is—why is that a
problem? Who’s the sucker? Playing the sucker (video) What EMOTIONAL error did the SUCKER display? When did the sucker CEASE to be a sucker? What is the main error–man, especially male, beginning investors—exhibit?
a) That’s a problem because it shows one’s inability to read the people and stakes which is essential in poker. b) Emotions as per the cards dealt, overconfidence in his game and assuming others to be suckers. c) Never ( or when he is out of that game ) d)
Overconfidence in own ability and confusing luck with genius.
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What is the key to investment success?
Swinging the pitch when the odds are in favour (margin of safety) and playing the game long (Compounding)
What TYPE of market participant seeks Mr. Market for investment guidance? Do
you notice any conflicts, ironies or problems? Or can it be a way to improve your investment results? -
Investors who don’t do their own work and have little independent opinions.
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They seek the guidance from the market to beat the market. Irony ??
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Not as per me.
How do many investors react to huge market volatility?
Buying and selling at wrong timings ( Too much activity) Mistaking Price to be the barometer for company’s performance (confusing volatility with risk)
Did Mr. Graham give you a way to access the valuation of a common stock?
Explain.
The way Graham talks about valuation is to look at the assets and value them in order of their surety as an asset. For examples : The most predictable and sure-shot
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assets is Cash , marketable Securities (even for Indian Investors, Satyam Fiasco even challenged that hypothesis). Moving up the order, value inventories at a reasonable discount (depending on the nature and uniqueness of the inventory) and so on moving up to Working Capital and then to fixed assets. Basically, the idea is to separate the value a business based on facts from the value based on perceptions of future.
Extra credit: Did Graham ever give a FORMULA for determining intrinsic
value? Be careful and read the footnotes to the formula he presents and why he offers it to readers. See Intelligent Investor.
No, He mentioned the Value = (Normal Earnings
* 8.5 + expected annual growth
rate) as a formula to replace the complex formulas for roughly estimating value but since it included the ‘expected growth rate’ component, it can never give you the intrinsic value. It on the other hand can tell you what’s built in the price.
Anyways, there is often misunderstood point by investors. Graham in security analysis clearly mentioned that it’s not important to know the exact weight of a person to tell whether he is grossly overweight or underweight (something on these lines, I may be wrong in the wordings). One can have a broad range of fair value and make their buying decision based on the margin the current price offers from that range but there obviously cannot be a single formula for intrinsic value
What is the biggest mistake investors make when buying securities? How would
you prevent that? What does Graham do?
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Letting the Price and volatility to drive the buying behavior. Graham ensured margin of safety as sacrosanct and diversify to reduce the risk. I prevent that by keeping a watch on the performance of the companies I am interested in and buying them when there are temporary tailwinds or events that have more effect on perception and not on company’s fundamentals per se.
What is the danger in growth stock investing?
No margin of safety, not many things have to go wrong for you to lose money
What is a good or bad stock/investment?
Well, I would just like to reiterate Graham’s definition of Investment here.
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
When during the past fifty years were the greatest American companies
(Franchises mostly) bad investments. Why?
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Do not follow American Markets, All my answers will be based on google search and driven by hindsight bias so would refrain from answering this.
What is the best approach to take in investing?
Invest with Margin of Safety
What is risk?
Risk is not knowing what you are doing and hence increasing the probability of permanent loss of capital.
Why do so many “smart” people fail at investing or at least do less well than
simple stock indexes over time?
Greed and Fear. Not sticking to one investment philosophy and being continuously guided by the market.
What are the five investment criteria in the Behavioral Portfolio
Management? Dividends
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Analysts Earning Estimates High Debt Companies Negative Net Worth Price to Sales
What is the cult of emotion?
Markets are referred to as Cult of emotions as prices are driven by emotion
Is it possible for emotion to help you as an investor?
Well, other people’s emotions certainly do. The whole idea is to bet against the crowd when the odds are in your favour.
--
Do you agree that deep value investing is an investment triumph disguised as business disaster? As my experience with investing started five years ago I can only say that panic is the best time to buy stocks. What do you see as the biggest investment risk(s) in “deep value investing?” Even if you buy at a big discount, if the industry is bad (like the textile business that Buffet bought and later sold) or if the managers turned out to be dishonest or inexperienced (for example they don’t know how to integrate a new company after a merger) you can still lose money. When do stocks appear most attractive and when is the risk highest?
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They appear most attractive when the discount is the biggest. The risk is highest when the company is at the beginning of the cycle when earnings are the peak. What is considered the main margin of safety metric? The discount to intrinsic value. What are investors rewarded for? They are rewarded for discovering mispricing opportunities between intrinsic value and market value. What concept must you truly grasp to be a successful deep value investor? Intrinsic value. Why do prices move more than intrinsic value? Because Market is driven by emotion. True or False: A good value investor understands and takes advantage of the behavioral biases of others because he has already eliminated them in him/herself? False. We all have biases and the way I try to eliminate them is using an investment checklist. Deep value investing often means buying distressed assets but can you buy a franchise (see attachment of Wal-Mart or a company able to grow with profits above its cost of capital due to barriers to entry) at deep value prices? Name two investments by Buffett that might fit that criteria? WMT_50 Year SRC Chart Amex and Gillette. How can we think of activist investing? As a way to good buy companies that have been under performing their peers for some years and need a change in management to catch up with benchmark. Icahn, Bill Ackman and Chris Hohn are good example of activists. What are your goals for this course? Continue learning value investing and meet interesting investors How do Mr. Graham and Mr. Buffet view buying a share of stock? As a stake in a business. What do you do if you can’t find an attractive investment? Hold the cash and wait for the opportunity to come. What is Mr. Market’s purpose? Set prices based on emotion
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How are prices set? in Philadelphia it’s worth fifty Bucks (video) Based on the perception of the buyer (for how much he can re-sell the asset, supply/demand). Are prices based on subjective or objective valuation? Prices are based on subjective valuation of future growth earnings prospects. If you are playing poker and you don’t know who the sucker is—why is that a problem? Who’s the sucker? Playing the sucker (video) What EMOTIONAL error did the SUCKER display? When did the sucker CEASE to be a sucker? What is the main error–man, especially male, beginning investors— exhibit? Main error is excessive confidence that it is learned after a big loss. What is the key to investment success? Be consistent with your method and continue learning every day. What TYPE of market participant seeks Mr. Market for investment guidance? Do you notice any conflicts, ironies or problems? Or can it be a way to improve your investment results? Manic depressive and irrational participants. How do many investors react to huge market volatility? They react in extremes by selling if market is going down or by buying if going up. Did Mr. Graham give you a way to access the valuation of a common stock? Explain. Yes, by inverting P/E, comparing it to treasury bonds and determine margin of safety Extra credit: Did Graham ever give a FORMULA for determining intrinsic value? Be careful and read the footnotes to the formula he presents and why he offers it to readers. See Intelligent Investor. Average EPS for the last 5 years divided by share price should give return higher than treasury bonds What is the biggest mistake investors make when buying securities? How would you prevent that? What does Graham do? Biggest mistake is buying when earnings are at peak. Prevent by buying at a big discount. Graham buys at the end of cycle when earnings are lower. What is the danger in growth stock investing? It ignores reversion to the mean, competitors and it is based in future prospects. What is a good or bad stock/investment? Price paid determines the rate of return.
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When during the past fifty years were the greatest American companies (Franchises mostly) bad investments. Why? When the price was at the top and then fall during crisis. What is the best approach to take in investing? Buy a franchise when it is hurt during a crisis. What is risk? Permanent loss of capital. Why do so many “smart” people fail at investing or at least do less well than simple stock indexes over time? They try to beat the crowd by following the crowd in their own ways. They don’t have a defined circle of competence. They pay too high a price or chose the wrong industry/business/managers.
-Max Figueroa MBA Class of 2012 | Darden Graduate School of Business
University of Virginia | Tel: (917) 825 9335
Blog: maxfdarden.wordpress.com |
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Chapter 20: “Margin of Safety” as the Central Concept of Investment by Benjamin Graham In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three
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words, we venture the motto, MARGIN OF SAFETY.1 This is the thread that rounds through all the preceding discussion of investment policy--often explicitly, sometimes in a less direct fashion. Let us now, briefly, to trace that idea in a connected argument. All experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin of above charges may be stated in other ways—for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.) The bond investor does not expect future average earnings to work out the same as the in the past; if he were sure of that, the margin demanded might be small. Nor does he rely to any controlling in his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time. The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise2 with the amount of debt. (Ditto for preferred stock issue) If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically —before the bondholders will suffer loss. The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results. So much for the margin-of-safety concept as applied to “fixed-value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications. There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against it property and earning power 3. That was the position of a host of strongly financed industrial companies at the low price levels of 1932-33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal
1
Buffett has been quoted as saying these three words (Margin of Safety) are the most important concept in investing. Your mindset is important. The investor allows for being wrong; for having a margin of error built into his/her process. Don’t drive a 9,000 pound truck over a bridge built to hold 10,000 pounds, drive a 5,000 pound truck.
2 Graham means total enterprise value or (fully diluted shares outstanding x price) plus market value of all debt minus excess cash not used for operations.
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appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.) Common stocks bought under such circumstances will supply an ideal, through infrequent, combination of safety and profit opportunity. As a quite recent example of this condition, let us mention once more National Presto Industries Stock, which sold of a total enterprise value of $443 million in 1972. With its $16 million of recent earnings before taxes the company could easily have supported this amount of bonds. In the ordinary common stock, brought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated these points with the following figures: Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favor. Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values. Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 450% of the price paid. This figure is sufficient to provide a very real margin of safety—which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchase in the upper levels of the market, or in buying non-representative common stocks that carry more than average risk of diminished earning power.
As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid. 4 Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost. He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account. On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety. For that reason we felt that there are real risks now even in a diversified list of sound common stocks. The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for
3 “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn yearafter-year if the business conditions prevailing during the period were to continue unchanged” (Security Analysis, 1934 ed., p 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely approximate a company’s earning power per share by taking the inverse of its P/E ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9 or 1 divided by 11.
4
Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of the Intelligent Investor was written, the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now in 1972 there is no difference between the earnings rate on stocks and the interest rate on stocks and I say there is no margin of safety…you have a negative margin of safety on stocks….
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otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars. Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him. However, 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 time of favorable business conditions. The purchasers view the current good earnings as equivalent to “Earning Power” and assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege. It is then also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth. (Graham speaks of the growth illusion and the dangers of paying a price for a franchise—paying over asset or replacement value—because investors confuse the continuation of high earnings during rosy economic times with the average earnings power of the company. For example, paying peak earnings for a cyclical company is usually a disaster). These securities do not offer an adequate margin of safety in any admissible sense of the term. Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970-71. The same is ordinarily true of common-stock earnings if they are to qualify as indicators of earning power. Thus 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. The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-ofsafety principle. The growth stock buyer relies on an expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future. Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid. (This concept is critical for growth investors). The danger in a growth-stock program lies precisely here. For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of estimates, when they differ from past performance, must err at least slightly on the side of understatement. The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole. The margin of safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. They buyer of bargain issues places particular
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emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company’s prospects. True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose. THEORY OF DIVERSIFICATION There is a close logical connection between the concept of safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business. Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more colorful by a reference to the arithmetic of roulette. If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.” In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with a 0 and 00.) 5 A CRITERION OF INVESTMENT VERSUS SPECULATION Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please. Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation. We think this skepticism is unnecessary and harmful. It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation. We suggest that the margin of safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one. Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system
5
In “American” roulette, most wheels include a 0 and 00 along with numbers 1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you $1 on every number? Since only one slot can be the one into which the ball drops, you would win $25 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning. Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” For most investors, diversification is the simplest and cheapest way to widen your margin of safety.
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is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase. By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data. We believe, also that it is well supported by practical investment experience. There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. But, equally, there is no valid reason for pessimism on this score. Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience. EXTENSION OF THE CONCEPT OF INVESTMENT To complete our discussion of the margin of safety principle we must now make a further distinction between conventional and unconventional investments. Conventional investments are appropriate for the typical portfolio. Under this heading have always come United States government issues and high grade, dividend paying common stocks. We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features. Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States saving bonds. Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two thirds or less of their indicated value. Besides these, there is often a wide choice of medium grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value. In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first-quality rating is synonymous with a lack of investment merit. It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity provided that the buyer is informed and experienced and that he create a substantial margin of safety, the security thereby meets out criterion of investment. Our favorite supporting illustration is taken from the field of real estate bonds. In the 1920s, billions of dollars’ worth of these issues were sold past par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character. In the depression of the 1930’s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some case below 10 cents on the dollar. At that stage the same advisors who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type. But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonable safe—for the stated values behind them were four or five times the market quotation* *Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worse company is worth buying if its stock goes low enough. (James Grant of Grant’s Interest Rates Observer says there are no bad bonds just bad bond prices). A company may be a great investment when its stock price is depressed relative to its normal earnings power and asset values while becoming a terrible investment at another high price of its stock. Look at the lesson of the “Nifty Fifty” from the Go-
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Go years of the late 1960s and early 1970s. Those high quality companies like Avon, IBM, P&G became one decision stocks to be held forever even at absurdly high prices. This concept was crushed during the bear market of 1973/1974 when stock prices of those companies declined 50% to 80%. The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. The “speculative” profit was the purchasers’ reward for having made an unusually shrewd investment. They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. Thus the very class of “fair weather investment” which we stated above is a chief source of serious loss to naïve security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price. (The very people who considered technology and telecommunication stocks a “sure thing” in late 1999 and early 2000,when they were hellishly overpriced, shunned them as “too risky: in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe. Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham and simple common sense would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up— from investing, or buying on the basis of what the underlying business is worth. The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicted on a thoroughgoing analysis that promises a larger realization than the price paid. Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation. To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of “common stock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.) 6 The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. At the moment they have no exercisable value. Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss. If that is so, there is a safety margin present even in this unprepossessing security form. A sufficiently enterprising investor could then include an option-warrant operation in this miscellany of unconventional investments. To Sum Up
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
6
Graham uses “common stock option warrant” as a synonym for “warrant,” a security issued directly by as corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters.
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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. The first and most obvious of these principles is, “Know what you are doing—know your business.” (circle of competence). For the investor this means: Do not try to make “business profits” out of securities —that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in. A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money. A third business principle: “Do not enter upon an operation—that is, manufacturing or trading in an item —unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure--as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal. A fourth business rule is more positive: “Have the courage of your knowledge and experience. 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.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand. Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities with the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks. -
What is risk? While its meaning may seem nearly as fickle and fluctuating as the financial markets themselves, risk has some profound and permanent attributes. The people who take the biggest gambles and make the biggest gains in a bull market are almost always the ones who get hurt the worst in the bear market that inevitable follows. (Being “right” makes speculators even more eager to take extra risk, as their confidence catches fire.) And once you lose big money, you then have to gamble even harder just to get back to where you were, like a racetrack or casino gambler who desperately doubles up after every bad bet. Unless you are phenomenally luckily, that is a recipe for disaster. No wonder, when he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financer, J.K. Kingenstein of Wertheim & Co. answered simply: “Don’t lose.”
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Losing some money is an inevitable part of investing, and there is nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money. The Hindu Goddess of wealth, Lakshmi, is often portrayed standing on tiptoe, ready to dart away in the blink of an eye. To keep her symbolically in place, some of Lakshmi’s devotees will lash her statue down with strips of fabric or nail its beet to the floor. For the intelligent investor Graham’s “margin of safety” performs the same function: By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed. Consider this: Over the four quarters ending in Dec. 1999, JDS Uniphase Corp., the fiber-optics company, generate d$673 million in net sales, on which it lost $313 million, its tangible assets totaled $1.5 billion, Yet on March 7, 2000, JDS Uniphase’s stock hit $152 a share, giving the company a total market value of roughly $143 billion. And then like most “New Era” stocks, it crashed. Anyone who bought it that day and still clung to it at the end of 2002 faced these prospects: 10.2 years to break-even at 50% CAGR. Even at a robust 10% annual rate of return, it will take more than 43 years to break even on this overpriced purchase! THE RISK IS NOT IN OUR STOCKS, BUT IN OURSELVES Risk exists in another dimension: inside you. If you overestimate how well you really understand an investment, or overstate your ability to rise out a temporary plunge in prices, it doesn’t matter what you own or how the market does. Ultimately, financial risk resides not in what kinds of investment s you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and stop up to the mirror. That is risk, gazing back at you from the glass. As you look at yourself in the mirror, what should you watch for? The Nobel-prize-winning psychologist Daniel Kahneman explains two factors that characterize good decisions: Well-calibrated confidence” (do I understand this investment as well as I think I do?) Correctly-anticipated regret? (How will I react if my analysis turns out to be wrong?) To find out whether your confidence is well calibrated, look in the mirror and ask yourself: “What is the likelihood that my analysis is right?” Think carefully through these questions: How much experience do I have? What is my track record with similar decisions in the past? What is the typical track record of other people who have tried this in the past? If I am buying, someone else is selling. How likely is it that I know something that this other person or company does not know? If I am selling, someone else is buying. How likely is it that I know something that this other person or company does not know?
END
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Benjamin Graham's view of Margin of Safety7
Dec 5, 2004
Benjamin Graham, frequently referred to as "the father of value investing" defines margin of safety as: earning power of the company - return on long-term risk-free bonds Where a company's earning power is calculated by taking the company's average earnings per share over the last several years, and dividing this by the share price. For example, suppose Jack's Furniture Company (not a real company) trades at $17.5 per share, and suppose its earnings per share over the last several years have been: $1 $1.2 $1.3 $1.65 $1.75 From these results, it looks like this company is growing at approximately 15% per year and is trading at a P/E ratio of 10. Graham, however, would suspect that the company's earnings only grew because of temporary factors. For example, perhaps the economy is doing particularly well at the moment, leading people to purchase more furniture than usual. Graham might expect that in the future, the company's earnings will fall to a lower level. He would likely say, the earning power of the company is the average of the company's earnings over the last several years, or: 1 + 1.2 + 1.3 + 1.65 + 1.75
7 Source: http://www.bronsteinreport.com/grahammos.htm
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--------------------------------5
=
$1.38 per share.
Dividing $1.38 into the share price of 17.5, we get an earnings yield of 7.8%. If long term treasury bonds are returning 5%, the company is trading at a margin of safety of 7.8% - 5%, which is 2.8%. This means, the company's earnings yield is 2.8 percentage points higher than is necessary for the stock to perform as well as risk-free bonds. If the company performs worse than we expect, and the company's earning power turns out to be only $0.88 per share, the return on the stock will likely be roughly equal to the return on 30-year treasuries. So, according to Graham's theory, Jack Co is likely a better investment than long-term bonds, even if the company's earnings fall significantly. This concept of "margin of safety" is quite conservative, but that doesn't make it useless. It might be worth considering.
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Buffett, Klarman and Graham on the Parable of Mr. Market
These investors will describe the mental attitude that an investor should take towards prices.
Warren Buffett once said that if he was teaching a class on investing he would focus on two things:
1. How to value a business 2. How to think about prices
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These notes will examine prices and Mr. Market.
Berkshire Hathaway 1987: Marketable Securities - Permanent Holdings
Whenever Charlie (Munger) and I buy common stocks for Berkshire's insurance companies we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts not as market analysts, not as macroeconomic analysts, and not even as security analysts.
Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success.8 He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
8 See Graham’s writings on “Mr. Market” on pages 7 and 8.
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Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market; you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy." (Never invest without knowing your edge.)
Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, 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
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behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.
Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben 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.
--
Seth Klarman mentioning Mr. Market in Margin of Safety
Foreword
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When I was a boy I spent some time in a ranch in Montana. On Saturday nights we would drive into town to a cozy tavern where there was a perpetual poker game. This arrangement provided the house with two advantages from which it profited mightily. First, it sold whiskey to the players, and second, it furnished a permanent dealer—a girl, as it happened—who didn’t drink herself. The cowboys’ mission was to have a good time after a tough week. Hers was to make money for her employer. She knew the odds, (she was rational) and almost always pulled further and further ahead as the night wore on and the cowboys, lubricated by booze, became ever jollier and more prone to exciting but illogical bets (emotional investors, the Cowboys were Mr. Market, Ben Graham’s term for the emotional swings in the market).
In all games the difference between the amateur and the professional is that the professional plays the odds, while the amateur, whether he realizes it or not, is among other things a thrill seeker. Investment, too, is part science and part a game, and just as in poker, you need to sort out your motives. The essence of the whole matter is buying a company in the market for less than its appraised value. Fortunately, most of the other investment players are quite emotional, so if you are thorough and patient, you can find good deals. However, they will rarely be easy, since many other people are looking for the same thing. Thus, to prosper in the investment game, as in any other, requires that you be right—so you’ll win—and different—so you’ll get attractive odds. I hope that this book will help you do that.
Taking Advantage of Mr. Market
Financial-market participants must choose between investment and speculation. Those who (wisely) choose investment are faced with another choice, this time between two opposing views of the financial markets. One view, widely held among academics and increasingly among institutional investors, is that the financial markets are efficient and that trying to outperform the averages is futile. Matching the market return is the best you can hope for. Those who attempt to outperform the market will incur high transaction cost and taxes, causing them to under perform instead.
The other view is that some securities are inefficiently priced, creating opportunities for investors to profit with low risk. This view was perhaps best expressed by Benjamin Graham, who posited the existence of a Mr. Market, an ever helpful fellow, Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides
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this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy or to sell. Frequently, however, he becomes irrational. Sometime he is optimistic and will pay for more than securities are worth. Other times he is pessimistic, offering to sell securities for considerable less than underlying value. Value investors—who buy at a discount from underlying value— are in a position to take advantage of Mr. Market irrationality.
Some investors—really speculators—mistakenly look to Mr. Market for investment or for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their Holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying long-term success.
Mr. Market’s daily fluctuations may seem to provide feedback for investors’ recent decisions. For a recent purchase decision rising prices provide a positive reinforcement; falling prices, negative reinforcement. If you buy a stock that subsequently rises in price, it is easy to allow the positive feedback provided by Mr. Market to influence your judgment. You may start to believe that the security is worth more than you previously thought and refrain from selling, effectively placing the judgment of Mr. Market above your own. You may even decide to buy more shares of this stock, anticipating Mr. Market’s future movements. As long as the price appears to be rising, you may choose to hold, perhaps even ignoring deteriorating business fundamentals or a diminution in underlying value.
Similarly, when the price of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned. They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell at just the wrong time. Yet if the security is truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more. Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market. The fact that a stock rises does not ensure that the underlying business is doing well or that the price increase is justified by a
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corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration 9.
It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market— ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.
Security prices move up and down for two basic reasons: to reflect business reality (or investor perceptions of that reality) or to reflect shortterm variations in supply and demand. Reality can change in a number of ways, some company-specific, others macroeconomic in nature. If Coca-Cola’s business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value. If Aetna’s share price plunges when a hurricane causes billions of dollars in catastrophic losses, a decline in total market value approximately equal to the estimated losses may be appropriate. When the shares of Fund American Companies, Inc. surge as a result of the unexpected announcement of the sale of its major subsidiary, Fireman’s Fund Insurance Company, at a very high price, the price increase reflects the sudden and nearly complete realization of underlying value. On a macroeconomic level a broadbased decline in interest rates, a drop in corporate tax rates, or a rise in the expected rate of economic growth could each precipitate a general increase in security prices.
Security prices sometimes fluctuate not based on any apparent changes in reality, but on changes in investor perception. The shares of many biotechnology companies doubled and tripled in the first months of 1991, for example despite a lack of change in company or industry fundamentals that could possibly have explained that magnitude of increase. The only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing.
9
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In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason. Supplyand-Demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. Most day-to-day market prices fluctuations result from supply-and-demand variations rather than from fundamental developments.
Investors will frequently not know why security prices fluctuate. They may change because of, in the absence of, or in complete indifference to changes in underlying value. In the short run investor perception may be as important as reality itself in determining security prices. It is never clear which future events are anticipated by investors and thus already reflected in today’s security prices. Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.
Unsuccessful Investors and Their Costly Emotions
Unsuccessful Investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money buy only a few minutes to invest it. The same people would read several consumer publications and visit numerous stores before purchasing a stereo or camera yet spend little or no time investigating the stock they just heard about from a friend. Rationality that is applied to the purchase of electronic or photographic equipment is absent when it comes to investing.10
Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless 10 Read Ayn Rand’s books, Atlas Shrugged and The Fountainhead which provide a philosophical underpinning to the belief that man’s greatest
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gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. 11 Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.
Summary of a Boom/Bust Cycle
High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before. As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify ever higher prices, and a mania can ensue. In the short run resisting the mania is not only psychologically but financially difficult as the participants make a lot of money, at least on paper. Then, predictably, the mania reaches a peak, is recognized for what it is, reverses course, and turns into a selling panic. Greed gives way to fear, and investor losses can be enormous.
Junk Bond Mania
As I discuss later in detail, junk bonds were definitely such a mania. Prior to the 1980s the entire junk bond market consisted of only a few billion dollars of “fallen” angels.” Although newly issued junk bonds were a 1980s invention and were thus untested over a full economic cycle, they became widely accepted as a financial innovation of great importance, with total issuance exceeding $200 billion. Buyers greedily departed from historical standards of business valuation and creditworthiness. Even after the bubble burst, many proponents stubbornly clung to the validity of the concept.
11 An intelligent investor will always ask who is on the other side of the trade from him or her and why do I have this opportunity? Who has the edge? Humility will help you.
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The Relevance of Temporary Price Fluctuations
In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. (Beta fails to distinguish between the two.) Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals. But are temporary price fluctuations really a risk? Not in the way that permanent value impairments are and then only for certain investors in specific situations.
It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term, forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact, while investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.
If you are buying sound value at a discount, do short-term price fluctuations matter? In the long-run they do not matter much; value will ultimately be reflected in the price of a security. Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. For example, short-term price declines actually enhance the returns of long-term investors.12 There are, however, several eventualities in which near-term price fluctuations do matter to investors. Security holders who need to sell in a hurry are at the mercy of market prices. The trick of successful investors is to sell when they
12 Consider the example of a five-year 10 percent bond paying interest semiannually which is purchased at par ($100). Assuming that interest rates remain unchanged over the life of the bond, interest coupons can also be invested at 10 percent, resulting in an annual rate of return of 10 percent for that bond. If immediately after the bond is purchased, interest rates decline to 5 percent, the bond will initially rise to $121.88 from $100. The bond rises in price to reflect the present value of 10 percent interest coupons discounted at a 5 percent interest rate over five years. The bond could be sold for a profit of nearly 22 percent. However, if the investor decides to hold the bond to maturity, the annualized return will be only 9.10 percent. This is less than in the flat interest case because the interest coupons are reinvested at five percent, not 10 percent. Despite the potential short-term profit from a decline in interest rates, the return to the investor who holds on to the bonds is actually reduced. Similarly, if interest rates rise to 15 percent immediately after purchase, the investor is faced with a market decline from par to $82.84, a 17 percent loss. The total return, if he holds the bond for five years, is increased, however, to 10.99 percent as coupons are reinvested at 15%. This example demonstrates how the short-term and long-term perspectives on an investment can diverge. In a rising market, many people feel wealthy due to unrealized capital gains, but they are likely to be worse off over the long run than if security prices had remained lower and the returns to incremental investment higher.
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want to, not when they have to. Investors who may need to sell should not own marketable securities other than U.S. treasury bills.
Near-term security prices also matter to investors in a troubled company. If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company’s stock and bonds.
The third reason long-term oriented investors are interested in short-term price fluctuation is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.
--
The Intelligent Investor by Benjamin Graham, Rev. Ed. Pages 204-206
Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects are you know them Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposed seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him or in the case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
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The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
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. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell. --
Commentary by Jason Zweig on Graham’s Mr. Market
The happiness of those who want to be popular depends on others; the happiness of those who seek pleasure fluctuates with moods outside their control; but the happiness of the wise grows out of their own free acts—Marcus Aurelius
Most of the time, the market is mostly accurate in pricing most stocks. Millions of buyers and sellers haggling over price do a remarkably good job of valuing companies—on average. But sometimes, the price is not right; occasionally, it is very wrong indeed. And at such times, you need to understand Graham’s image of Mr. Market, probably the most brilliant metaphor ever created for explaining how stocks can become mispriced. The manic-depressive Mr. Market does not always price stocks the way an appraiser or a private buyer would value a business. Instead, when stocks are going up, he happily pays more than their objective value; and, when they are going down, he is desperate to dump them for less than their true worth.
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The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to.
One of Graham’s most powerful insights is this: “The investor who permits himself to be stampeded or unduly worried by unjustified market decline in his holdings is perversely transforming his basic advantage into a basic disadvantage.”
What does Graham mean by those words, “basic advantage”? He means that the intelligent individual investor has the full freedom to choose whether or not to follow Mr. Market. You have the luxury of being able to think for yourself. 13
Recognize that investing intelligently is about controlling the controllable. You can’t control whether the stocks you buy will outperform the market today, next week, this month, or this year; in the short run, your returns will always be hostage to Mr. Market and his whims. But you can control:
o
your own behavior, by avoiding constantly watching your portfolio, listening to CNBC and market prognosticators and other “experts.”
o
your expectations, by using realism, not hope to forecast your returns.
o
your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying, and by rebalancing.
13 When asked what keeps most individual investors from succeeding, Graham had a concise answer: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.” See “Benjamin Graham: Thoughts on Security Analysis”, Financial History magazine, no. 42, March 1991, page 8.
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Just remember that investing really isn’t about beating others at their game. It is about controlling yourself at your own game. --
Disadvantages of Market Analysis as Compared with Security Analysis in Security Analysis, 2nd Edition, pages 703-706.
We return in consequence to our earlier conclusion that market analysis is an art for which special talent is needed in order to pursue it successfully. Security analysis is also an art; and it, too, will not yield satisfactory results unless the analyst has ability as well as knowledge. We think, however, that security analysis has several advantages over market analysis, which are likely to make the former a more successful field of activity for those with training and intelligence. In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove a satisfactory one. In market analysis there are no margins of safety; you are either right or wrong, and, if you are wrong, you lose money. Viewing the two activities as possible professions, we are inclined to draw an analogous comparison between the law and the concert stage. A talented lawyer should be able to make a respectable living; a talented, i.e., a “merely talented,” musician faces heartbreaking obstacles to a successful concert career. Thus, as we see it, a thoroughly competent securities analyst should be able to obtain satisfactory results from his work, whereas permanent success as a market analyst requires unusual qualities—or unusual luck.
The cardinal rule of the market analyst that losses should be cut short and profits safeguarded (by selling when a decline commences) leads in the direction of active trading. This means in turn that the cost of buying and selling becomes a heavily adverse factor in aggregate results. Operations based on security analysis are ordinarily of the investment type and do not involve active trading.
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A third disadvantage of market analysis is that it involves essentially a battle of wits. Profits made by trading in the market are for the most part realized at the expense of others who are trying to do the same thing. The trader necessarily favors the more active issues, and the price changes in these are the resultant of the activities of numerous operators of his own type. The market analyst can be hopeful of success only upon the assumption that he will be more clever or perhaps luckier than his competitors.
The work of the securities analyst, on the other hand, is in no similar sense competitive with that of his fellow analysts. In the typical case the issue that he elects to buy is not sold by someone who has made an equally painstaking analysis of its value. We must emphasize the point that the security analyst examines a far larger list of securities than does the market analyst. Out of this large list, he selects the exceptional cases in which the market price falls far short of reflecting intrinsic value, either through neglect or because of undue emphasis laid upon unfavorable factors that are probably temporary.
Market analysis seems easier than security analysis, and its rewards may be realized much more quickly. For these very reasons, it is likely to prove more disappointing in the long run. There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.
Prophesies Based on Near-term Prospects
A good part of the analysis and advice supplied in the financial district rests upon the near-term business prospects of the company considered. It is assumed that, if the outlook favors increased earnings, the issue should be bought in the expectation of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide. The market prospect is thought to be identical with the business prospect. But to our mind the theory of buying stocks chiefly upon the basis of their immediate outlook makes the selection of speculative securities entirely too simple a matter. Its weakness lies in the fact that the current market price already takes into account the consensus of opinion as to future prospects. And in many cases the prospects will have been given more than their just need of recognition. When a stock is recommended for the reason that next year’s earnings are expected to show improvement, a twofold
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hazard is involved. First, the forecast of next year’s results may prove incorrect; second, even if correct, it may have been discounted or even over discounted in the current price.
If markets generally reflected only this year’s earnings, then a good estimate of next year’s results would be of inestimable value. But the premise is not correct. Our table on page 729 shows on the one hand the annual earnings per share of United States Steel Corporation common and on the other hand the price range of that issue for the years 1902–1939. Excluding the 1928–1933 period (in which business changes were so extreme as necessarily to induce corresponding changes in stock prices); it is difficult to establish any definite correlation between fluctuations in earnings and fluctuations in market quotations.
In the Appendix, Note 70, we reproduce significant parts of the analysis and recommendation concerning two common stocks made by an important statistical and advisory service in the latter part of 1933. The recommendations are seen to be based largely upon the apparent outlook for 1934. There is no indication of any endeavor to ascertain the fair value of the business and to compare this value with the current price. A thorough-going statistical analysis would point to the conclusion that the issue of which the sale is advised was selling below its intrinsic value, just because of the unfavorable immediate prospects, and that the opposite was true of the common stock recommended as worth holding because of its satisfactory outlook.
We are skeptical of the ability of the analyst to forecast with a fair degree of success the market behavior of individual issues over the near-term future—whether he base his predictions upon the technical position of the market or upon the general outlook for business or upon the specific outlook for the individual companies. More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavor:
1. The selection of standard senior issues that meet exacting tests of safety.
2. The discovery of senior issues that merit an investment rating but that also have opportunities of an appreciable enhancement in value.
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3. The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value.
4. The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations.
-From: Your Money and Your Brain by Jason Zweig, pages, 31-32
Stocks have prices, businesses have values.
In the short run, a stock’s price will change whenever someone wants to buy or sell it, and whenever something happens that seems like news. Sometimes the news is nothing short of ridiculous. On October 1, 1997, for examples, shares in Massmutual Corporate Investors jumped by 2.4% on 11 times their normal trading volume. That day, WorldCom announced a bid to acquire MCI Communications. Massmutual’s ticker symbol on the NYSE is MCI—and hundreds of investors evidently rushed to buy it, believing the stock would rise after WorldCom’s takeover offer. But MCI Communications traded on NASDAQ under the ticker symbol of MCIC—so the price of Massmutual’s stock had shot up in a farce of mistaken identity. …
In the long run a stock has no life of its own; it is only an exchangeable piece of an underlying business. If that business becomes more profitable over the long term, it will become more valuable, and the price of its stock will go up in turn. It is not uncommon for a stock’s price to change as often as a thousand times in a single trading day, but in the world of real commerce, the value of a business hardly changes at all on any given day. Business value changes over time, not all the time. Stocks are like weather, altering almost continuously and without warning; businesses are like climate, changing much more gradually and predictably. In the short turn it is the weather that gets our notice and appears to determine the environment, but in the long run it is the climate that really counts.
A Little Trick from Warren Buffett
All this motion can be so distracting that Warren Buffett has said, “I always like to look at investments without knowing the price—because if you see the price, it
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automatically has some influence on you.” Conductors have likewise learned that they can evaluate a classical musician more objectively if the audition is played from behind a screen, where no preconceptions about how the musician looks can affect the perception of how he or she sounds.
Therefore, once you become interested in a company, it is a good idea to let two weeks go by without ever checking its share price. At the end of that period, now that you no longer know exactly where the shares are trading, do your own evaluation--ignoring stock price and focusing exclusively on business value. Start with questions like these: Do I understand this company’s products or services? If the stock did not trade publicly, would I still want to town this kind of business? How have similar firms been valued in recent corporate acquisitions? What will make this enterprise more valuable in the future? Did I read the company’s financial statements, including the “statement of risk factors: and the footnotes where the weaknesses are often revealed?
All this research, says Buffett, really points you back to one central issue: “My first question, and the last question, would be, ‘Do I understand the business?’ And by understand it, I mean have a reasonably good idea of what it will look like in five or ten years from an economic standpoint.” If you aren’t comfortable answering that basic question, you shouldn’t buy the stock.
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