A closer look at Mr. Market’s characteristics, and those who benefit from him
What similarities do Enron and Worldcom have with the 2008 financial crisis? At first glance, one would expect none. Due to their good reputation, Enron and Worldcom were not so easily spotted frauds coming to light while the 2008 crisis entailed a systemic problem. In all three cases Mr Market bailed in a highly depressed state; such is his nature in the midst of turmoil, fear and uncertainty.
Before continuing with Mr Market, let’s consider the problem of hindsight versus foresight. Looking back, it’s obvious that Enron and Worldcom were frauds. Both companies cooked their books and misled investors. But how about looking forward? Are material fraudulent acts easily spotted at companies with an apparently good reputation? Let’s look at some examples. Similar to James Chanos’ destructive report on Enron in 2001, numerous bears have recently attacked companies that are still standing. A good example is hedge fund manager Bill Ackman’s crusade against Herbalife in 2013 and 2014. Or Kyle Bass (Trades, Portfolio) on the inevitable collapse of Japanese government debt. Although all these situations resemble a canary clearly audible in the coal mine, accurately timing the pending crisis is the daunting task. Therein lies the problem of foresight, the problem of "when."
Revisiting Mr Market. According to Buffett and Graham, the astute investor (Mr. Astute) smells opportunity when Mr Market shows depressed behavior, willing to shed his assets at any price. Was Mr Astute wise to ignore the offers on Worldcom and Enron? Should he have concluded the 2008 meltdown to be Enron-like with a whole system collapsing under its lies of triple A rated mortgage securities? The subtle answer can be gained from thorough analysis of Warren Buffett’s career or that of his peers:
- Ignore the offers for common stock in the Enron and Worldcom cases – companies without a multi decade track record - but do consider the offered debt in these companies.
- In the midst of a wider melt down, buy quality common stock, where candidates have been identified by earlier analysis.
How to consider the debt: When the business is complex or not easily understood, Mr. Astute may consider outstanding debt, preferably offered at huge discounts. A glance at the balance sheet should reveal the presence of considerable tangible assets. It’s worth noting that BRKÂ indeed bought a former Enron pipeline during the turmoil. Naturally, that was a big transaction, outside the reach of the average smaller investor. On the other hand, he or she can identify such assets from the 10-K or 10-Q as good cover for outstanding debt.
How to buy quality common stock. One paradigm is to buy when there is blood on the streets. Obviously that requires some psychological preparation: How do you prepare for the worst? For a 1929, 1987 or 2008 event? What mental models guide Mr. Astute's thinking in the heat of the moment? When the world ending seems near and CEOs start calling their wife to brace for impact? Warren Buffett (Trades, Portfolio) correctly cited imagining the unimaginable as an important quality for his successor in BRK, or any good investor. Because when the unimaginable arrives, simple stable high-quality businesses survive the storm or even benefit from it. It’s Mr. Astute’s job to patiently wait for Mr. Market to offer those quality businesses in desperation.
And how about timing and foresight, when should Mr. Astute act? The answer can only come from experience combined with available funds and personal risk appetite. With debt in lesser companies, bankruptcy proceedings can take years. Meanwhile the tangible assets should limit the risk of loss of principal. And for the common shares in quality companies? Mr. Astute should be ready to buy even more when prices decline further.
Concluding
- Have a firm understanding of quality, and a regularly updated list of companies passing the test. Understanding quality is understanding business, management and return on capital. Mr. Market’s lack of understanding of these concepts explains his behavior, making him highly susceptible to social proof. “The other guys are selling, so I better sell, too.”
- Mentally rehearse different scenarios, from the most optimistic to the most unimaginable. This enables you to automatically transform into Mr. Astute when Mr. Market starts offering. Not rehearsing these scenarios automatically puts you in the Mr. Market crowd.
R-Vriesde
Sources: (1) Warren Buffett (Trades, Portfolio) 2002 letter to shareholders; (2) SEC spotlight on hedge funds, James Chanos; (3) Benjamin Graham, The Intelligent Investor, chapter 8. (4) Kyle Bass (Trades, Portfolio) Blog.
