Monday, July 23, 2007

An investing lesson

The purchase of the Washington Post Company (WPC) by Berkshire Hathaway in 1973 provides an almost perfect blueprint in investing. Here’s a brief history of this classic investment example.

In 1973, Berkshire Hathaway bought all of her WPC holding at a price of not more than one-forth of the then per-share business value of the enterprise. Calculating the price-to-value ratio required no unusual insights. It was around the nifty-fifty years at that time, either at its peaks or the turn of the peak. Most of the security analysts, or media executives then would have estimated WPC’s intrinsic business value at $400 to $500 million just as Berkshire Hathaway did. And its $100 million stock market valuation then was published daily for all to see. The advantage Berkshire then had was attitude: They learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values even if there’s a chance prices would drop much further.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. If you look at WPC’s market value in 1985, this would seem hard to believe. By 1985, WPC’s market value was $205 million for Berkshire’s share of the business. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore, calculations of business value were of no importance in investment activities.

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974, Berkshire’s WPC holding showed a loss of about 25%, with market value at $8 million against their cost of $10.6 million. What Berkshire had thought to be ridiculously cheap a year ago had became a good bit cheaper as the market, in its infinite wisdom, marked WPC’s stock down to well below 20 cents on the dollar of intrinsic value.

Like Skim milk masquerades cream, WPC’s golden goose was hidden ten feet under the soil. To yet fatten the goose, WPC had an able steward in place – the late Katherine Graham. She had the brains and courage to repurchases large quantities of stock for the company at those bargain prices, as well as the managerial skills essential to dramatically increase business values. In the midst of these events, investors began to recognize the exceptional economics of the business and the stock price inched closer to the underlying value. Thus, Berkshire experienced a triple dip: the company’s business value soared upward, per-share business value increased considerably faster because of stock repurchases and, with a narrowing of the discount, the stock price outpaced the gain in per-share business value.

Lessons to be adopted:

1) If Warren Buffett had been led astray by the ticker on the Geiger counter, monitoring the price of WPC on a day to day, month to month, quarter to quarter, or year to year basis, he would not have been able to show the kind of result which he showed a dozen years later. By sticking to his principle of price versus value, and if he is able to buy at a price well below the business value, he would not allow market sentiments or personal sentiments to creep in and dictate when he should enter or exit the market. What guides him to either enter or exit the market is the business value of an enterprise. For example, if WPC is trading at a market value of $100 million while its business value is $400 million, he would not allow himself to delay his purchase just because he feels or thinks the price may goes yet lower. It is important to acknowledge it is impossible to either catch the top or the bottom stock price. The two ends at which the price of a stock will end up is in fact incalculable. However, the value is not.

2) Business value is the only wise and logical yardstick that defines proper investing. By being guided by the movement of price, the proper picture is lost.

3) Know the value, not the price. Just like if you do not know the horse, you’d better know the jockey.

4) Between 1973 and 1985, the value of DOW is pretty flat. However, the change in market value for WPC soared from $100 million to $1.8 billion. Who says you should be dictated when to invest or not to invest in a bull or bear market? In all markets, if you find a stock where the price is great, you should ignore what the general market is fairing even if it is at its peak.

5) During the end of 1974, Mr. Buffett would have looked like a fool if the market then had either been better than him or at par. But who’s the wiser by 1985? It would seems foolish and unthinkable how one could even consider buying WPC in 1973 for $100 million when the price would dip even lower by end of 1974 if you were a market participant in those early years of 1970s. But by 1985, if you were a market participant then, you would think it hard to believe that how those security analysts and the general investing community would be willing to sell WPC 20 cents on the dollar. Well, the market has been this way since the dawn of Wall Street. It happened in the past, it’ll repeats or rhymes in the future. And yet, there’re already a few stock which are probably priced at 50 to 70 cents on the dollar in today’s market, and we are talking of really fabulous businesses with brand names to match.

6) To try to get in and out of the market and winning each and every time you make an investing decision either to buy or sell, it is impossible to get it right each time. Investing based on technical means buying and selling as the risk of beta decreases or increase, this naturally leads to more trading activities. Let’s ignore the notion that technical investing does not even take into account the business economics, we shall focus on the number of attempts an investor will make between technical investing and intelligent investing. In technical, a typical investor will make numerous tries, each time trying to push the buy or sell button faster or harder than the next buyer or seller. In intelligent investing, a typical investor will only make a couple of trading activities based on the changes in the price of the stock in relation to the business value. Mathematically, the more you try, the less your chances of getting it correct. The more concentrated your activities, the more you stand to win. Logically, if you concentrate on a few things, the few things would be a lot stronger in base than if you were to concentrate on many things. If you know only one woman, you’d get to know her very well. But if you have a harem of women, it’d be hard to know each of them well. If Sir Isaac Newton is alive, he would probably come up with the forth law of motion – as motion increases, return decreases. A business value does not change in a short span of time like how stock prices do unless some basic fundamental changes. To thus constantly change the price of the stock that trades between a wide price band is foolish. In technical investing, it is simply just an easy way which investors mistook that represents the value of the business. It needs no rocket scientist to figure what is the peak or the bottom of a price range for a 52-week period. That is essentially technical analysis. But for intelligent investing, it simply ignores the 52-week high and low of a stock price. It just simply measures what price you should pay for the present value that the business will produce over its remaining life time. If the present value of all future cash flow of A is $100, and it is available at $50, you buy. If it is traded at $95, you skip. So when you know the value, you insist for a discount, just like you would build a bridge, you’d insist that the bridge carries 30,000 pound. But when you drive a truck across it, you’d only carry 10,000 pound. This is margin of safety.

7) Investing is a long haul game. What can safeguard your principal and gains is to understand what you are doing. The only way is intelligent investing. Although technical investing or buying on trends or the next sexiest stock can show you a gain in the short term, it’ll not go on infinitely by not showing a loss. Technical investing is akin to gambling, an investor of such kind can win a few rounds, even up to 10 or 20 rounds on the trot. Like a typical gambler in a casino, such investor does not know the odds are stacked against them and the odds are with the house. Why? Importantly, they do not know how to calculate if the odds are on their side. If you decide to gamble, you should only gamble knowing the odds. For example, in blackjack, the card of 5 is the most valuable to the house, so if you could the number of 5s that have been dispersed, you would know the odds have reduced in the favor of the house with the remaining cards in the pack. You’d then be able to deploy more of your stake when the number of 5s left is less, and less of your stake when the number of 5s are fully in the pack. Back to investing, in a bull market, it is easy for investors to indulge in technical or buying on trends and yet win. Easy money sedates rationality and simply leads to complacency. Investors of such kind could win 10 times on the trot. But just as market sentiments turn, on the next try, investor loses all back, they’d be lucky to even retain their principal. Any mathematical formula that multiplies by a zero will always be a zero regardless if the numbers preceding it is a million by a million. What an investor wants to avoid is the probability of the zero ending up in their investing formula. If you happen to be an investor who swears by technical or buying on trends, and you’re already making a million by a million, you should think if the next multiplying number is a zero.

8) When conditions are right like WPC – the right business economics and good management that sell well below the business value – will produce grand-slam home runs. People like Warren Buffett does not try to predict the stock market, whether the market is going up, down, or sideways in the near or intermediate future. What Warren does know is that occasional outbreaks of two super-contagious diseases – fear and greed – which will forever occur in the investment community. The timing of these epidemics will be unpredictable, both as to the duration and degree. Thus, investors of Warren type would never try to anticipate the arrival or departure of either disease – they simply do not try to play god. When people are greedy, Warren is fearful, when people are fearful, Warren is greedy. He should get scared when people start agreeing with him. As this is written, certain hot sectors show little fear on the Singapore scene. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Nothing simply gets better than effortless money. Unfortunately, stocks cannot outperform businesses indefinitely. Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the company they hold. If Singapore businesses, on aggregate, earn about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.


1 comment:

fishman said...

Good post to refresh on the principles of value investing! Nowadays when I go shopping with my fiancee, I try to look out for businesses that are competitive and tangibles. Baiscally I'm literally looking for stock ideas out in the streets!