In a 2007 speech at MIT, Seth Klarman said the following:
“Right at the core, the mainstream has it backwards. Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money—successfully for 24 of those 25 years—and, by investing cautiously and not losing, ample returns have been generated.”
While Klarman also points to pure risk avoidance like Buffett, he doesn’t appear to conclude that one should preserve capital in a vacuum; as noted in the closing sentence, ample returns can be generated by “investing cautiously and not losing.”
This probably sounds like an oxymoron to many people, particularly in terms of equities: The general consensus seems to be that investing in stocks, by its very nature, is a risky act. Cautious investing is only achieved through the purchase of fixed income products, where the cash flows are determined prior to the investment.
Personally, I think “investing cautiously” is directly applicable to equities, and can be done while still providing the opportunity for ample returns; I think the distinction is derived from the explicit guarantee offered by a fixed income product in comparison to the implicit guarantee offered by most dividend paying equities (for the sake of this argument, that is subset of the equity universe that’s comparable to bonds).
As everyone knows, a bond comes with a set coupon amount, which the purchaser will receive at set dates until maturity, when the principal is returned in full (par value). Let’s compare this to Coca-Cola (KO) common stock: At the start of the time period we’re reviewing today (2002), the stock was trading at roughly $60 per share, or just shy of 50x earnings.
At that time, only one factor in the cash flow calculation was known with near certainty: In the coming year, you would receive four dividend payments of $0.20 per share, resulting in a going-in yield of 1.33%; however, you were left in the dark on two other critical pieces of information: the expected payouts in the remaining years to maturity (let’s assume we are comparing this instrument to a 10-year treasury bond), and the principal (stock price) that would be returned to you at maturity. Looking at the 50x earnings figure in the starting period, many investors are probably cringing in fear (rightly so) about the terminal value that would be returned to the equity investor.
Interestingly, the investor would have fared better than expected. Compared to the 5.2% ten-year Treasury bond a buyer could have snagged in January 2002, let’s see how our Coca-Cola investor would have turned out (assuming $1,000 invested in each security and no reinvestment):
|Year||KO Stock (16.67 shares)||Ten Year Treasury|
|2011||$31.34 + $1166.90||$52 + $1000.00|
Using Coca-Cola’s year-end 2011 stock price of roughly $70, we can see that the cumulative cash outflow from the equity investment total $1387.02, a cumulative return of 38.7% and an annualized return of 3.33% for the decade. While this return is not as attractive as the return from the ten-year Treasury, it should come with a caveat for the investor of 2012.
First, the going-in valuation for Coca-Cola in this exercise was ridiculous; anytime you are paying a multiple of 50x on peak earnings for a company with a $100 billion or higher market cap, you are soon to be the victim of the law of large numbers. In that case, the investor was acting with anything but caution. Today, the multiple implies a much more realistic future growth rate and comes with a 2.5% dividend yield to boot.
Secondly, the yield on treasuries has contracted significantly over the last decade, with the current yield of 1.61% equal to less than one-third of the going-in rate in 2002. These two factors alone eliminate any reasonable ex-ante return comparisons among KO common and treasuries (how much of a risk premium does the most valuable brand in the world require?), particularly if one believes that the company’s 50-year streak of consecutive dividend per share increases will stay in track for another decade.
My point is a simple one: While it’s easy to get caught up in the notion that fixed income “guarantees” are justification for accepting low single-digit yields, it’s important to remember that capital preservation must be put into context; intelligent capital allocation can result in the “just right” mix of cautious investing and the potential for ample returns – and with the tables turned from the extremes of just a decade ago, fixed income investors have some serious thinking to do about just how “cautious” they are currently being.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.