Thursday, October 19, 2006

Belts and suspenders approach

In stock picking, the "belts and suspenders" approach is a commonly used method advocated by the creator to the way of intelligent investing. This approach is also known more commonly as the "margin of safety" approach.
In this method, an equity investor should treats how the way he purchases business like the way he purchases groceries in a supermart. If 100 grams of beef fillet goes for $1 every once a year, then a shopper should buy as much as he can. Normally, the fillet would perhaps costs $3 per 100 grams. Thus, in investing, it must be treated in the same mentality. But sadly, this seems to be the only area where people are manic-depressive - investors chase price when it goes up and sells when it comes down.
For Benjamin Graham, he is only interested to buy stocks selling for less than intrinsic value. If a company is worth X, he will only invest in it for less than X. This is his margin of safety - his "collateral." If he was wrong, or if some unforeseen event reduced his estimate of the company's value, he wanted a cushion. He wanted "belts and suspenders" for his stocks. The premise was that if he bought shares in a business for less than they were worth to a knowledgeable buyer of the entire company, he had a margin of safety.
Buying stocks at below its intrinsic value will certainly produce a superior result compared to those who did not. However to start with, an investor must certainly strive to be a knowledgeable owner. Being knowledgeable ensures an investor knowing where he can acquires more than what he pays.
Here's how investing below intrinsic value causes superior results. As most investors are aware, most businesses increase their net worth or intrinsic value over time. If intrinsic value is your benchmark, you can profit in two ways. First, the value of the shares you own will increase while you own them - works very much like compounding effect. Second, if the price of the stock rises from less than intrinsic value to intrinsic value over time, you will have a win-win situation. But, if you pay full price for the stock - a price equals to its intrinsic value - your future gain may only be limited to the company internal rate of growth and the dividends it may pays you. But an investor must always be aware that in equity investing, "value adding" does not exist, it's merely just a system for wealth-transfer between the parties engaged. Investors who trade among themselves are never adding any business value to the company. Think of it critically, if there are only 10 investors in a room trading stocks. Whatever price they pay in order to buy a business from the other sellers, the price which they pay do not go into the business, it ends up in the seller's pocket. So the buyer does not adds any value that the business is already conducting, neither does the seller takes any value away from the business. What has changed hands is only the ownership from one to another without any thing taken out or pump into the business. The only "value-adding" activity that has happened was to the seller who managed to offload his stake at a higher price than he had paid for.
If you think of the S&P 500 index as a giant conglomerate with 500 divisions, you will observe that over long periods, its earnings have grown on average 6% yearly. Typically, 3% of the increase has come from the growth of gross national product, and 3% from inflation. Thus, the intrinsic value of the S&P 500 thought as a single company increases about 6% a year. In addition, the S&P 500 pays a dividend. Historically, the dividend yield of the S&P 500 has been in the range of 3% to 4%. If you take the sum of the long-term earnings growth of 6% and the dividend yield of 4%, you get a long-term annually compounded return of about 10%. This is the return investors in an index fund should logically and realistically expect to make over the long term. Of course, to be able to make the 10% return, they must stay in the fund long enough. Investing in stocks is unlike putting your money in a savings account. In a savings account, both your principal and returns are fixed. You will not see fluctuation to its value at any time. However, in stock investing, returns and principal will fluctuate perpetually from year to year, sometimes dramatically. The 10% return is only an average of some bang-up years and some gut-wrenching years. So if an investor is the sort who chases prices and time the market by buying and selling, I can guarantee he or she will perpetually be underperforming the market to the extent of losing a chunk. Here's the logic. For these investors, they only buy when price is on the up, and then sell when it is on the down. How can they even expect to make much or any profit, or even to the extent of matching the market performance, when the logic is not correct? Essentially, it means they buy stocks during the boom years, normally at a price that is already "drum" way up, and then they sell when stocks are downhill. Now you must be asking how did they do such a foolish thing? This is really a psychological factor that is almost peculiar to only investing. Investor feels good when prices are drummed up and during such times, they feel great to pump in money because they feel prices will always be on a perpetual upslope. Conversely, it is the same when conditions are depressed. Investors feel prices will perpetually fall or at minimal will remain flat for a long time, thus, they think by selling when prices are going down, they can buy it back later when they are further down. But sadly, when prices go even lower, they are afraid to buy it. Frankly, any one without some fundamental logic will never be able to benefit from the field of investment in the long run. In the short run, they may be smart, but in the long run, intelligent investment will be correct.
What an investor would like to have is some mechanism that forces you into the market when stocks are cheap and eases you out or keep you on the sideline when they are dear. And the premise and principal of this mechanism is the same for all intelligent investor, that is to buy a business at below intrinsic value - i.e. having a margin of safety or belts and suspenders. Getting in at the bottom of the stock market always produces superior results than getting in at the top.
None of the other approaches can produce a better constant long-term result than the way of intelligent investing. There may be many other "sexier" approaches in investing but like the old Chinese saying goes "good to see, lousy to eat."

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