Wednesday, August 01, 2007

Mindset when buying into businesses or marketable securities

I’m writing on the approach into buying into common stocks, and to some extent, the approach to buying a controlling stake in an entity. When buying into marketable security, the approach to the transaction is as if we are buying into a private business. We must look into the economic prospects of the business, the people in charge running it, and the price we must pay. We do not mind if the transaction is made at any time as long as the price is attractive. Indeed, we must be willing to hold a stock indefinitely as long as we expect the business to satisfactorily increase its economic value. When investing, we should view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, or not even as security analysts.

This approach makes an active trading market useful since it periodically presents investors with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of the trading in the securities market should not in any way bother investors any more than does the lack of daily quotations of that security. Eventually, an investor’s economic fate is determined by the economic fate of the security they hold.

Ben Graham long ago described the mental attitude toward market fluctuation that I personally truly believe to be the most conducive to sustained investment success. He said that you should imagine market quotations as coming from a remarkably accommodative and manic-depressive fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market will appear daily and name you a price at which he will either buy your interest or sell you his. The option to buy, sell or ignore him is entirely up to you.

Even though the business that the two of you own may have stable economic characteristics, Mr. Market quotations will be anything but. For, sad to say, the poor guy has incurable emotional problems. At times, when he feels euphoric and can see only the favorable factors affecting the business, he names a very high price to buy out your interest because he fears that you will snap up his interest and rob him of imminent gains. At other times, when he is depressive and can see nothing but trouble ahead for both the business and the world, he will name a very low price since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation today is uninteresting to you, he will be back tomorrow with a new one. Transactions are strictly at your discretion. Under these conditions, the more manic-depressive he is, the better for you.

But, like Cinderella at a ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is in his pocketbook that you will find useful, not his wisdom. If he shows up one fine day in a particularly foolish mood, you are free to either ignore him or to take advantage of him. But it will be disastrous if you fall under his influence. Indeed, if you are uncertain that you understand and can value your business far better than Mr. Market (which unfortunately majority of the market participants are), you don’t belong in the game. As they say in poker, “If you’ve been in the game for half an hour, and you don’t know who the patsy is, you’re the patsy.”

Ben’s Mr. Market metaphor may seem out-of-fashion in today’s investment world, especially in a particularly hot market. Professional and academics alike talk of efficient markets, dynamic hedging, diversification, trend investing, whatever you call it. Their interest in such talks is understandable since techniques covered by mystery clearly have value to the seller of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?

In my opinion, investment success – not fly-by-night success – will not be produced by arcane formulas, computer programs, charts, or signal flashed by the price behavior of stocks and markets. Rather an investor will succeed only by combining good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. It is the second part that is way harder than the first. In order to stay insulated, it is highly useful to keep Ben’s Mr. Market fable firmly cast in mind.

Following Ben’s teaching, we should allow the common stocks guide us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while (the duration can drag for years), but eventually it will confirm it. As Ben said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” The speed at which a business’s success is recognized is not that important as long as the business’s economic value is increasing at a satisfactory rate. In fact, delayed recognized can be an advantage: It simply gives us more time and chance to buy more of a good thing at a bargain price. If you are a shopper, would you rather have Great Singapore Sale lasting one month or half a year?

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts indicate it would. In such case, we should sell our holdings – that means by selling, we’re getting more than a dollar of any future dollar from the business cash flow. Some other times, we should sell a security that is fairly valued or even undervalued because funds are needed for a still more undervalued security or one we believe we understand better.

However, it needs to be stressed that we need not sell holding just because they have appreciated or because we have held them for a long time. One maxim of Wall Street I find foolish is “one can’t go broke by taking a profit.” As long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business, we should be contented to hold any such security indefinitely.

In some other extreme situations which I firmly believe, if a business is managed by an extraordinary manager who both has the business savvy and honesty, I’ll not in any circumstances consider selling the holdings even in an extreme overvalue situation. Call me bonkers if you will. This is more slanted towards personal value rather than economic gains. Thus, a determination to hold or to have a stock or a wholly owned business, obviously involves a mixture of personal and financial considerations. To some, this stand seems very eccentric. But then David Ogilvy said, “Develop your eccentricities when you are young. That way, when you are old, people won’t think you are going ‘ga-ga’.” To many on Wall Street, both companies and stocks are treated only as raw material for trading. But then, it is understandable why they do that and it is totally alright, just that, the way I think it should be done is a much better and superior and humane method.

Whichever attitude investors chose to follow, the adopted attitude should fit their personality and the way they want to live their lives. Winston Churchill once said, “You shape your buildings at first and then your buildings shape you.” I know the way in which I wish to be shaped and for this reason, I would rather achieve a return of X while associating with people whom I firmly like, strongly admire rather than to realize 110% of X by exchanging these relationships for uninteresting, self-centered or unpleasant ones.

We know how management consultants prescribe companies on how many people should report to any one executive, but it hardly makes any sense. When you have able managers of high character running a business about which he is passionate, you can have a dozen or even more reporting to you and still have time for an afternoon nap. But if you have even one inept manager reporting to you who is deceitful, inept, and uninteresting, you will find yourself with more than you can handle. By associating with only people you like and admire, it not only enhances your chances of a good result but also ensures an extraordinarily good time which no material things in the world can buy. On the other hand, working with people who makes your stomach churns seems much like marrying for money – probably a bad idea under any circumstances, but if you are already rich, it is absolute madness.

In all cases, we should try buying into businesses with favorable long-term economics. The prudent and modest investor is to find businesses at a bargain price. Successful investors like Warren Buffett, and Charlie Munger have found making silk purses out of silk is the best that they can do; with sow’s ears, they fail.

For market participants who are not convinced by this method, you would find solace that even Warren Buffett required 20 years to recognize how important it is to buy good businesses. In the prior period, he too searched for “bargains” and had the misfortune to find some. The punishment was an education in the economics of short term farm manufacturers, third-rate department stores, and textile manufacturers.

Owning marketable securities though have numerous disadvantages compared to controlled entity. But sometimes, it is offset by a huge advantage: Occasionally, the stock market offers the chance to buy non-controlling pieces of an extraordinary business at truly ridiculous price – dramatically below those commanded in negotiated transaction that transfer control (think LBO, or even the recent News Corp offer for Dow Jones, although most are offered overvalued).

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