Saturday, August 25, 2007

What is investing?

The strategy for sustainable investing remains little change since the dawn of Wall Street. Purchasing marketable stocks is akin to purchasing and evaluating businesses in its entirety. We should want a business that is one to be a) we can understand; b) with favorable long-term prospects and economics; c) operated by honest and competent people; d) available at an attractive price.

Maybe you will ask how does one decide on an attractive price. In answering this question, most analysts feel they must choose between two approaches which they thought to be customarily opposite in nature. The two approaches are “growth” and “value.” However, many investment professionals view any mixing of the two approaches as a form of intellectual cross-dressing.

However, Mr. Warren Buffett, thinks the two approaches are joined at the hip: He remarked, “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

Then the term value investing is kind of redundant. If investing is not for seeking more value, then what else could it be for? At any time, by consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – must be labeled as speculation.

Whether the term value investing is appropriate or not, it is widely used. Typically it implies the purchase of stocks having attributes such as a low ratio of price to book value, a low price to earnings ratio, or a high dividend yield. Such characteristics, unfortunately, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is thus truly practicing on the principle of obtaining value in his investments. On the other hand, the opposite characteristics – a high price to book ratio, a high price to earnings ratio and a low dividend yield – are in no way inconsistent with a value purchase.

On the same note, business growth, per se, reveals little about value. It’s true that growth often has a positive impact on value, sometimes one of extraordinary proportions. But such a conclusion is far from certain. For example, in the past, investors have regularly poured money into the airline industry to finance profitless growth. For these investors, it would have been better if the Wright brothers did not even invent the airplane. The more the industry has grown, the worst the disaster for owners.

Investors can benefit from growth only when the business in point can invest at incremental returns that are enticing. That is to say for each dollar used to finance the growth, each of such dollar must creates over a dollar of long-term market value. In the case of a low-return business needing incremental funds, growth will hurt investors.

Written over 60 years ago, John Burr Williams, set forth in his book, The Theory of Investment Value, the equation of value, which is condensed here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.”

An investor should buy the investment shown to be the cheapest by the discounted cash-flow calculation regardless of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates or return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. The first type of business is, unfortunately, very hard to find. Most high-return businesses tend to need relatively little capital. Shareholders of such business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Thought the mathematical calculations required to evaluate equities are not difficult, an analyst can easily go wrong in estimating future “coupons.” There’re two ways to mitigate the problem. First, try to stick to businesses that we think we can understand. To me, that means they must be relatively simple and stable in character. If a business is complex or subject to constant change, I’m just simply not smart enough to predict the business future and ultimately, the future cash flow. Ironically, this shortcoming should not bother you. In fact, it is a strength rather than weakness. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistake.

Second, and as important, one must insist on a margin of safety in their purchase price. If one calculate the value of a common stock to be only slight higher or lower than its price, one should be disinterested in buying. This principle of margin of safety brought to us by Ben Graham is the cornerstone to investment success.

1 comment:


Trying to improve ones lot. That would best describe investing.