As the world embraces the new year, the financial world has wasted no time in tossing out forecasts for the market indices as well as churning out the usual lists of stocks that they predict are going to outperform for the year. One of the things I resolved to do this year was spend even more time ignoring them, and to solidify my commitment to improving my process and approach. Meanwhile, as uncertainty about the global economy looms, and people oscillate between greed and fear, there is even more need to approach 2016 with the level headed ideas of Benjamin Graham that would form the cornerstones of value investing for decades to come.
1. Investment vs Speculation:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
There is something very interesting about this statement in that nowhere does Benjamin Graham mention anything about a time period. The reason for this that some operations would necessarily be short term: what is known as special situations, including things like company announced buybacks, spin-offs etc which might play out within a year. Other times you have companies that continue to grow their value year after year and that you may end up holding for more than a decade. What’s important is to have the discipline to only stick to investment cases made on facts and fundamentals that offer a good chance you’ll get your capital back with a decent return.
2. The Parable of “Mr Market”
“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 as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes 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 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”
The nature of markets is that when you have a large group of people making decisions there are bound to be times where group think and herd mentality causes prices to be set irrationally high or low. The fact that prices are set everyday set causes a lot of unnecessary mental anguish to people who spend time watching prices flash and the value of their holdings fluctuate when he or she would not bother with getting a quotation on his private business or real estate. Losses, even quotational ones further compound the problem as psychologically, they are twice as painful as the equivalent pleasure from a gain: something that behavioural finance recognizes as loss aversion. An investor would do well to see treat the market volatility as a tool to buy or sell when the price is right in reference to his assessment of value, and should avoid buying a stock simply because it has gone up or selling because it has gone down.
3. A rising tide lifts all ships
“The risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety”
Every bull market will see a wave of IPOs where promoters are eager to raise capital or cash out when the going is good, cyclical companies with tail winds in their raw material prices or above-normal demand and story stocks where there is little to no fundamental value but people have latched on to a story and the greed that goes with price rises leads to a rationalization that any price will be justified in the end. To be sure, the risk of over-payment for good quality is a very real one but it tends to work out over longer periods of the time, whereas a poor quality company that is propped up by temporary factors may never recover and lead to a permanent loss of capital.
4. Volatility is not the same thing as risk
“The bona fide investor does not lose money merely because the market price of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well-selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky,” it would then have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security”
Capital market theory says that the more a stock fluctuates, the higher its beta is and the more risky this is. This is not a true measure of risk if the investor is not forced to sell at an opportune time either through a financial commitment or because of outright emotional panic. Instead, risk occurs either when a company’s fundamentals deteriorate which could be for many reasons: technological change, management foolishness, competitive forces (Take the classic case of Kodak) ; or when the investor ends up paying too much (Tech companies in 2000). Either way, it comes from a mi-assessment of the company’s fundamentals, not because of the nature of markets causes stock prices to fluctuate. Furthermore, people often have an inverted view of risk, thinking that stocks are riskier when they go down and safer when they go up, often leading to a buy high, sell low phenomenon. This is of course, absurd: the same people are happy when they can shop for goods on sale but feel depressed when the stock markets offer things on sale.
5. Margin of Safety
“If a company could be assumed to grow at a rate of 8% or more indefinitely in the future its value would be infinite, and no price would be too high to pay for the shares. What the valuer actually does in these cases is to introduce a margin of safety into his calculations—somewhat as an engineer does in his specifications for a structure. On this basis the purchases would realize his assigned objective (in 1963, a future overall return of 7½% per annum) even if the growth rate actually realized proved substantially less than that projected
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.”
The need for margin of safety comes from an inherent truth to investing and life in general: the future is uncertain. The difficulty in forecasting future growth of a company makes it necessary to consider scenarios where things may not go as planned. If we assume that every price has a certain “growth rate” assumption baked into it by way of discounting cash flows back to the present, then there is a certain range of prices paid wherein it might the growth assumption is conservative or reasonable. Say you look at the current market price of a share trading at Rs 500 and you think the market is pricing in growth of 15%. If you pay 400, the growth rate may workout to only 12% keeping the same discount rate assumption. You thus make a reasonable return if the 12% scenario plays out and a fantastic return if the 15% assumption plays out. However if you pay 600 and need growth of 20%, then a great deal of luck comes into the picture.
Margin of safety need not come only from earnings – it can be calculated from asset value as well. If you had a company that had a net working capital of Rs 1000 crore, cash of Rs 200 crore and you paid Rs 800 crore for the entire business, you were essentially getting any fixed assets and growth for free. This sort of statistical bargain is not as common these days as it was in Graham’s time during the Great Depression, but it still might be found in out of favour industries. By constructing a portfolio where each case has a margin of safety present, on average the odds are you will do fine over time.
Warren Buffett summarized Graham’s ideas by saying “The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in that market.” He also pointed out that over the last few decades, these ideas still remain relatively unpopular, tossed aside with every market euphoria often with the declaration that “value investing” is dead. It’s just as well, Charlie Munger adds: “If people weren’t wrong so often, we wouldn’t be so rich”