Part 5 (1/2)
Recognizing that, due to both uncertainty and the presence of qualitative factors, a range of possibilities was the best that could be expected when assessing the underlying worth of a stock, Keynes adopted a ” safetyrst ” policy that sought to identify those stocks trad-ing at a substantial discount to even low - range estimated intrinsic value He realized that ” the amount of the risk to any investor princi-pally depends, in fact, upon the degree of ignorance respecting the cir-cu” In other words, as uncertainty surrounding expected future cashows increases, so too does the ” fuzziness ” of intrinsic value in of safety is required
Keynes observed that sohter calculation of intrinsic value than others, and are therefore more com-patible with a safetyrst policy In The General Theory he noted that:there are many individual investitimately dominated by the returns of the comparatively near futureIn the case ofpublic utilities [for example], a sub-stantial proportion of the prospective yield is practically guaranteed by e such rates as will provide a certain stipulated in
Warren Buffett repeated the point in a letter to Berkshi+re Hathaway stockholders, in which he commented that ” the more uncertain the future of a business, the more possibility there is that the calculation will be wildly off - base”
A Bird in the Hand Unquestionably, the really right policy would be to aih an income as possible, and not to trouble too much about capital valuations
-Keynes to the Chief Ofcer of National Mutual, January 19, 1939 The tenets of value investing - which dein of safety in respect of securities acquired - will naturally bias investors toward stocks with a relatively stable and sustainable earnings pro le Serial acquirers - corporate Pacs per-formance behind the latest acquisition - are of little interest to the value investor, nor are stocks offering the promise of ” blue sky ” returns at some indenite point in the futureWarren Buffett - a famous no - show at the Internet bender of the late 1990s - explained his preference, as an investor, for those stocks so ” : With coke I can coenerate in the future But with the top 10 Internet companies, how much cash will they produce over the next 25 years? If you say you don ' t know, then you don ' t knohat it is worth and you are speculating, not investing All I know is that I don ' t know, and if I don ' t know, I don ' t invest
In an undergraduate essay on the British philosopher and states that: Our power of prediction is so slight, our knowledge of remote con-sequences so uncertain, that it is seldoe in the future
Keynes ' observation was a rather baroque restatement of the proverb ” a bird in the hand is worth two in the bush” In the stock market arena, too, Keynes eventually adhered to this principle - ” ultiue promise of riches in so the worth of a stock
Warren Buffett si power ” before he commits capital to a particular security He notes that: The key to investing is not assessing howto affect society, or howthe coiven coe
It is earnings - not rowth, or the nov-elty of an industry - that will ultimately determine the value of a com-pany, and therefore its stock price A business that draws in 50 billion of revenue but, because of poor ins, ekes out the prot of a mar-ket stall is worth very little to the rational investor Si defensible barriers to co - ters, and therefore will be of little interest to the disciplined stock - picker
Maintaining an EdgeI a way ahead and anore immediate uctuations, if I a power are thereIf I succeed in this, I shall simultaneously have achieved safety - rst and capital prots
-Keynes to the Chairman of Provincial Insurance Company, February 6, 1942 Unlike many of his peers, Keynes did not harbor a secret desire to eometry” Economics is essentially a moral science and not a natural science,” he main-tained,” that is to say, it ements of value” Similarly, Keynes disclaimed the need for - or possibility of - precision in the stock market domainThe unavoidable presence of uncertainty - the fact that, in regard to the future, ” we simply do not know ” - combined with the existence of factors which impact on a stock ' s value but cannot be quantied,value of a stock is a necessarily inexact art
Accepting that intrinsic value can, at best, lie soe of values, Keynes developed a safety rst policy in respect of his stock acquisitions Considering both quantitative and non - numerical factors, he assessed ar power ” and coainst theprice for part - shares in that business By ” backing intrinsic valuesenormously in excess of the market price,” Keynes was con dent that he would achieve his stated objectives of both ” safetyrst ” and, eventually, capital gains
Warren Buffett ' s investment policy is very si a business is part art and part science ” and therefore advocates a in of safety - a nancial shock absorber - to compensate for this lack of precision: You also have to have the knowledge to enable you tobusinesses But you do not cut it closeThat is what Ben Grahain of safetyYou don ' t try and buy businesses worth 83 inWhen you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across itAnd that sa
Exactitude in the stock market arena is action - because of uncer-tainty, no one can value a security precisely The best response to this uncertainty, Keynes and Buffett argue, is to ensure a wide buffer exists between perceived value and quoted price Eventually, as the stockin of safety should be converted into an investor ' sinto the Wind
Apples for Peanuts Necessity never ain
-Benjamin Franklin, POOR RICHARD'S ALMANACK In March 1918 the German army - its eastern forces loosed after a treaty with newly Bolshevik Russia - gambled on a massive assault on the Western Front before the resources of that awakened giant,America, could be fully deployed Ground which had been so expensively purchased in previous years - thousands of men killed for every few hundred yards of swampy, torn earth - now yielded itself freely to the Central Powers, and in just a few days Sturmtruppen were encamped on the outskirts of Paris Froigantic guns capable of hurling payloads high into the stratosphere and e of the center of Paris
Unsurprisingly, the success of the Ger Offensive and the destruction inicted by the unseen ” Big Berthas ” generated enormous
panic in the French capital Thousands of Parisians streaainst this current of people was Maynard Keynes He had heard from his friend, the painter Duncan Grant, that the private collection of Edgar Degas was to be auctioned in Paris in late March Grant and the Blooovernment connections to obtain funds to bid for these artworks By proposing an ingenious sche French debts to Britain, and arguing that ” ne specimens of Masters ” would be a much better bet than nancially distressed French Treasury bills, Keynes extracted more than half a million francs from the Exchequer Keynes was so taken with the operation, in fact, that not only did he secure the as collection, but he also decided to attend the auction in person
As Big Bertha periodically belched forth another shell, Keynes and the Director of the National Gallery - who, in true cloak - and dagger style, had shaved off his moustache and donned spectacles to avoid detection by art dealers and the press - purchased twenty - seven paintings and drawings from the collection Prices were so depressed by the fear and uncertainty caused by the encircling enemy that - despite the quantity and quality of the acquisitions, including works by Gauguin, Manet, and Delacroix - a quarter of the Treasury ' s grant re respect of the Bloomsberries - one offered the backhanded compliment that ” your existence at the Treasury is at last justi ed ” - but it also proved a personal boon for Keynes Failing to convince his covert traveling partner of the ht the post - impressionist ' s celebrated still life, Apples, on his own account for the ridiculously small sum of 327
It would take more than a decade before Keynes applied the lessons learned in the Paris showroo the bandwagon - ju the turmoil of the late 1920s and early 1930s, he turned instead to a diametrically opposed invest a handful of stocks at prices offering a substantial discount to expected future earnings potential, regardless of the whims and fashi+ons of the market After many successes and reversals, Keynes had eventually discerned that the stock market could, on occasion, be hty, or propelled by informational cascades It was at these times that the value investor ' s contrarian reedy when others are fearful, and fearful when others are greedy ” came into its own
Fashi+on Victithens itself
What is not pronounced tends to nonexistence
-Czeslaw Milosz,” Reading the japanese Poet Issa ”
Belying his impeccable Establishious dissenters on both sides of his family This ancestral trait of nonconformism, in Maynard ' s case, seemed to extend well beyond hted in paradoxes, opposed accepted wisdom, and, as the social reforarden thoughts and eether in bundles” A policy of ” leaning into the wind,” as he so, was ideally suited to Keynes ' tee the ” perverse, Puckish ” side of his nature, but his natural inclination to run counter to conventional thinking also offered the tangible satisfaction ofnancial gain
Keynes rejected theinstead that, on occasions, a preponderance of ” game players ” over ” serious - ence between quoted prices and underlying stock value Like many other spheres of activity, stocks could be subject to the whi currents of infor prices or falling prices engender further declines Fred Schwed applied a characteristically cynical interpretation to this phenomenon: Those classes of investe froht to be the best are in truth only the most popular - the most active, the hest in price at that tienie hats or waxed e is, at times, patently not the exemplar of ef ciency that orthodox theorists clai its proclaimed role as a machine to crystallize expected future cash ows, the market on occasions succumbs to the funda buyers than sellers; in a despondent bearsellers than buyers
The ripples from these waves of optimism or pessimism affect even those stocks initially untouched by investor irrationality, as capital is channeled into ” hot ” stocks and away froent Investor: The erating ordinary vicissitudes into major setbacks Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels
This displacement effect was particularly evident, for exa days of the 1990s, when the rush to ” new econoes the ” TMT ” trinity of telecoy stocks broadly doubled in only a couple of years, while the derisively labeled ” old econoht
The Perils of Popularity If fty , it is still a foolish thing
-Anatole France (attributed) Even Berkshi+re Hathaway, that beacon of level headedness and contrarian values, appears itself to have been the periodic plaything of fashi+onAs Charlie Munger - who jokingly describes himself as ” assistant cult leader ” at the company - comments, ” e have created at Berkshi+reis, to some extent, a cult[and] I think it ' s had effects on the stock prices ofBerkshi+re” Some individuals have been known to acquire one or two Berkshi+re Hathaway shares ht to attend the stockholders ' annual er Conversely, in the last years of the 1990s - when Buffett was dismissed by many as a ponderous investment dinosaur doomed to extinction in the brave neorld of dot - coms - Berkshi+re ' s stock became less modish and, in consequence, suffered a rare period of underperformance relative to the market
Berkshi+re Hathaway' s experience is a case study in the life cycle of stocks - as - fashi+on accessories A stock is rst picked up by the cognoscenti because of some particular attribute - in Berkshi+re ' s case, the i approach As enthusiash the wider on, prices may overshoot any reasonable estimate of intrinsic value And when the stock inevitably falls out of favor - as happened with Berkshi+re Hathaway in the late 1990s, when investors deserted old economy stocks for the blue sky of Internet plays - prices ” overcorrect ” on the downside
A sierated - was seen on Wall Street in the late 1920s and early 1930s When Edgar Lawrence Smith published his seh the operation of retained earnings, stocks were effectively ” compound interest machines ” - launched the cult of the common stock A price trend, either up or down, over tirowth rates of around 30 percent in the three calendar years following publication of Lawrence ' s study Light - headed at these dizzying altitudes, the market subsequently overbalanced and fell into a chasht for the right reason in 1925, thereason in 1929” Stocks are contrary creatures - when they are reatest rewards, and when reatest potential hazard
Backing the Right Horse A difference of opinion is what ers, THE AUTOBIOGRAPHY OF WILL ROGERS The model that perhaps most resembles that of the stock market is the huainst other bettors, the odds on horses constantlyto reect the perceived favorites Additionally, horses are handicapped with varying weights in an atteood win record will carry heavier weights than less successful nags The stock market displays a very si and selling stocks based on their apparent prospects, and stocks perceived to have her price - to - earnings
In an ideal world - the world posited by efcient e by buyers and sellers will reect the relative s potential, of a security, so that each share is as good a bet as the other In an intervieith Outstanding Investor Digest, Berkshi+re Hathaway ' s Charlie Munger expanded on this point: Everybody goes [to the racetrack] and bets and the odds change based on what ' s bet That ' s what happens in the stock ht weight with a wonderful win rate and a good post positionis way more likely to win than a horse with a terrible record and extra weight and so onBut if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2 Then it ' s not clear which is statistically the best betThe prices have changed in such a way that it ' s very hard to beat the system
In a broadly efcient stock market - as with a correctly priced horse race - it is indeed extremely difcult to beat the system The key to success in both these arenas, therefore, is to identify the radically ood odds and has a strong chance of perfor the difculty of the investor ' s or bettor ' s task is the fact that ” the house ” - the stock exchange for the investor, the racing authority for the bettor - retains a percentage of each wager laid Although the stock e as that of the racetrack, and historically the stock er over time, the principle still holds - successful investors and bettors must not only out - bet the rest of the h to coer Success on the stock er reminds us, requires the individual ” to understand the odds and have the discipline to bet only when the odds are in your favor”