Most of us do not easily part with our money. We like to think of ourselves as shrewd. We want good, reliable information before making a purchase. Yet, something interesting often happens when we decide we want something – we change from a dispassionate rational shopper to falling in love with the object we desire – particularly when there is a real or perceived scarcity factor involved. Our rationality can quickly give way to anxiety, greed and impetuousness. It is as if the brain short circuits and goes directly for the kill, as other more balanced considerations fade into the background.
It was against the backdrop of this reality that Ben Graham formulated his wise and proven approach to investing, he himself having been almost wiped out by the 1929 crash. At its heart, Graham’s approach to investing is very simple and rests on a relatively small number of timeless principles. Buffett has traditionally singled out two: The Mr. Market parable which crystallizes the proper way to think about market prices and the Margin of Safety which both minimizes the possibility of permanent loss of capital and provides a hedge against human error and ignorance.
I would argue that an equally important principle is encapsulated in Grahams definition of investing itself as found in The Intelligent Investor, to wit, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” [Emphasis added]
Now, it is said that the road to hell is paved with good intentions. No value investor worth his salt would not agree that he should do his homework before pulling the trigger on a new investment. The problem comes when that dispassionate analysis gives way to the greedy impulsiveness described above.
“This one is going to get away.” “Its about to run up in price.” “So and so has already established a large position.” “I’ll initiate with a starter position.” Man’s capacity to rationalize is limitless, and his good intentions provide flimsy guardrails. None of these reasons even remotely equates to “thorough analysis”.
Thorough analysis is part of the margin of safety. It reduces mistakes. It squeezes out luck and injects skill into the equation. It fosters conviction – the kind that really counts when prices inevitably move against you in the short or medium term.
Do not skip thorough analysis. If you got away with it in the past, consider yourself lucky and resolve never to do it again. (The funny things about markets is that they can sometimes teach the wrong lessons.) Chances are you can look back over your investing career and identify several investments where you skipped this step and lost money. In investing, just playing good defense and not having periodic material losses will go a long way to improving your long-term compounding.
Think of thorough analysis as an intergal part of investing. Resolve to not commit capital if you do not do this. Consider selling positions where you skipped the thorough analysis, or at least roll up your sleeves now and do it for all your holdings. Most skip this at their own peril and, if you do it religiously, it will go a long way towards identifying market-beating investments.
I like to read through the back issues of Value Investor Insight as part of my search strategy. It is a good way to become familiar with a lot of different companies. There is also tons of solid investing wisdom to be had, as Whitney Tilson and his partners hand-pick the best modern practitioners of value investing in all its various forms.
One profile that recently caught my eye was that of Pacifica Capital which is run by Steve Leonard. Steve is a sharp guy who made a fortune in real estate by adroitly putting the lessons of Mr. Market to work in the real estate market. Then, in the late 90’s he formed a money management firm and built a strong performance record.
Steve is a focused value investor who concentrates his capital in stocks of good businesses with strong management. He is patient enough to buy them at attractive prices and then hold on as they appreciate, all of which brings me to the point of this article: patience.
Steve has a great quote on Pacifica’s website:
“With individual stocks, 10% of the time they’re cheap enough to buy, 10% of the time they’re expensive enough to sell, and the rest of the time you should just hold them if you own them and avoid them if you don’t.”
Sorry if this is not new information. But this series is about what it takes to beat the market – not being novel – and patience is about as fundamental to that objective as anything I can think of. All the great ones agree on this point and many are quick to point out that most investors – no matter how much they pay lip service to it – do not possess enough of it.
Buffett talks about investors inability to do nothing and just sit still. In distilling the essence of his investing discipline, he sings the praise of “lethargy, bordering on sloth.”
Why not double or triple your investment discipline (even if it cannot be measured with anything approaching precision)? Resolve to wait for the S&P 500 to be off by at least 20% before making a purchase. Or insist that a stock be on the new low list before loading up. Or wait for those magical times when the yield on normalized current earnings exceeds 15%. Or wait until your relatives or friends are asking if it would not be prudent to get completely out of the stock market, or – notwithstanding your esteem for the wisdom of the Mr. Market parable – you cannot help feeling a little queasy about your own equity holdings.
However you get there, limit your buying to the 10% of the time – per Steve Leonard – when stocks are really cheap. Otherwise, just sit still and prepare.
I have made the point in the past that, if you want to beat the market, you need to pick stocks of companies that have a higher mathematical expectancy than that of the S&P 500. Of course, this could come in many forms, for example, a higher earnings yield, better growth prospects, higher certainty in the company’s future prospects, or a cheaper stock price in relation to the business’s underlying assets.
To determine a stock’s mathematical expectancy, you need to do the math. For example, if you buy a stock that sells for a P/E of 30 and that you project to grow at 12% per year – something very few companies can do – for the next 10 years, what will your return be if it sells at a market-average multiple of 15 in year 10? It turns out that your return would only be about 4.5% – hardly mouthwatering! Moreover, you would have given yourself little or no margin of safety.
When he spoke at Columbia in 2010, Tom Russo explained how Buffett thought about Internet valuations during the tech bubble of the late 90’s. At the shareholder meeting, a questioner pressed Buffet on why he was not buying tech stocks such as Cisco. At the time, Cisco was earning about $1 billion annually and had a market cap of approximately $500 billion. Buffett started out by saying that the same $500 billion – Buffett often thinks in terms of buying the entire company – would earn $30 billion if invested in 10-year treasuries. Moreover, Buffett had some doubts whether the $1 billion in earnings was solid, given such items as options. So after year one, if you invested in Cisco, you would be in the hole for $29 billion in earnings. Take the analysis out two years and the earnings deficit would become much bigger still. Buffett doubted a person investing on these terms would ever catch up with the earnings forfeited by not simply buying treasuries.
There it is: simple math – no algebra, fancy spreadsheets, or Greek letters.
Next time you are looking at an investment, do the math. In fact, do the math on all your current holdings, if you have not already done so. Use common sense. Make reasonable assumptions. Consider what would happen if things do not go well. Build in a margin of safety.
It is not complicated, yet many do not have the discipline to do the basic blocking and tackling that makes all the difference. Resolve today to always “do the math”.
Coach Jon Gruden on “Monday Night Football” : The New Yorker – Great example of hard work and preparation.
A couple weeks ago, my favorite college football team was playing in their big rivalry game. It was a close game that went back and forth. At the two minute mark, my team had the ball, trailing by three, with an opportunity to win the game, if they could execute their two-minute drill and score a touchdown. Unfortunately, they fell short, not just because they did not make plays, but also because they seemed confused and poorly prepared.
Knowledgeable football fans know that the key to an effective two-minute drill happens long before the actual game. It is all about preparation. There is little or no time to figure it out in real time when you have the pressure of trying to come from behind and win the game.
For me, this was yet another reminder that you need to be prepared ahead of time in the markets. You cannot wake up on the morning of a big down day in the market and expect to make good decisions on what to buy if you have not already done your homework.
These are the days when opportunity presents himself. Buffett recently said he was buying heavily on the big down days in August. Templeton would do his valuation work when the markets were calm and then put in his standing purchase orders at deeply discounted prices. Then he would wait.
You need a well conceived watchlist if you want to beat the market. Your watchlist does not need to be long. It needs to be thoughtful. Start with a short list of high conviction ideas that you truly understand. Determine an appropriate buy price by valuing the businesses on the list and selecting a reasonably discounted entry point.
These optimal opportunities do not come along everyday, but they do happen. If you are honest, you can probably recognize many sub-optimal purchases that you have made because you missed these types of opportunities and were willing to pay too high a price for at least some of your securities.
Resolve to correct these poor tendencies. Read my eBook on the investment process for more advise on improving your process. There are no short cuts or magic valuation algorithms. It is about sweating the details day in and day out. That is how consistent market-beating performance is earned.