I have never favored calculating discounted cash flow, projecting growth rates or constructing spread sheets. I have always been of the opinion that such practices are typically exercises in futility which lend themselves to creating a false sense of security in the investor; instead, I attempt to invest in securities which I deem to have high risk/reward scenarios. After all, value frequently has little to do with mathematical models, which tend to either dazzle or confuse the average investor. Historically, some our greatest mathematical minds were legendarily poor investors. Witness Sir Isaac Newton who lost a fortune in the South Sea bubble when he crossed the line between intelligent investment and speculation - the proverbial apple that dropped upon his head must have skewered his judgment.
I believe that an intelligent investment is one in which the scales are either highly tipped toward the upside with a minimum of downside risk, or the potential gain could result in a significant multi-bagger. In the latter case, a total loss of capital is sometimes a distinct possibility; however, the opportunity for tremendous upside gains sometimes mitigates the added risk of the purchase. Some observers might refer to such a transaction as an educated speculation. The aforementioned opportunities frequently present themselves in technological and pharmaceutical sectors, although they might occur in low-tech sectors as well. Participation in educated speculation generally requires an inordinate understanding of a specific sub-sector, which is not well comprehended by the market or more commonly, the discovery of a business with a very small market capitalization which the market has overlooked. In thoroughbred handicapping vernacular, these wagers are referred to as “overlays” (bets in which the payoff is much higher than the true odds of winning). In other words, an animal which goes off at a price of ten to one, while holding an actuarial probability of winning one out of five times, is a sound investment. The rub lies in the fact that the handicapper still has only a 20 percent chance of cashing his ticket; further, his actuarial assessment may not correspond with reality. That is probably the reason that Benjamin Graham was not drawn towards race handicapping.
As an aside, a young Warren Buffett (Trades, Portfolio) was drawn toward the pursuit of thoroughbred handicapping, and at a tender age he could be seen outside the once legendary Ak-Sar-Ben (Nebraska spelled backwards) race track selling his “Stable Boy” tout sheet. Ak-Sar-Ben held a long-standing gambling monopoly in the heart of the Midwest located in Buffett’s home town of Omaha. The strength of the monopoly was verified by decades of extraordinary mutual handle, which quickly began to erode upon the opening of a dog-racing facility just across the river in Council Bluffs, Iowa. The dog-racing facility paved the way for the entry of slot machines and eventually full casino gambling, which struck a death knell to the once resplendent race course. Alas, similar to Brooklyn fans who witnessed their beloved Dodgers move to Los Angeles in 1958, I still feel a slight pang of when I drive by the old grounds, although the pain has diminished considerably with the passing of time.
The demise of Aksarben is analogous to the evolution of many other businesses. Had the race track been a publically-traded entity, it would have probably burned many investors who would not have foreseen its rapid demise. In a real sense, it would have been a classic “value trap”. I will continue this discussion later in the article when I address investment risk and the possibility that a business could become obsolete.
What Constitutes a Sound Investment?
Benjamin Graham described an investment as follows: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” So there you have it, straight from the horse’s mouth. The key phrases are “adequate return” and “safety of principal”; without the latter, the investor is crossing into the land of speculation which is a territory that frequently lands him/her on the storybook road to financial ruin.
The phrase safety of principal implies that an investment holds a margin of safety, generally in the form of a long history of earnings coupled with a strong balance sheet, and sufficient liquidity to absorb a financial downturn. The problem with investing in companies which boast the aforementioned characteristics is that that typically they only exist in a fantasy land, or more commonly, they supply an earnings yield which fails the “adequate return” clause. Such stocks become the focus of the dividend growth crowd which frequently embrace yield without regard to price; therefore, as Buffett has pointed out on numerous occasions, it is not enough to merely buy an outstanding company, one must also purchase shares at the proper price.
So what about intelligent speculation? Should an investor systematically eliminate any security from his list of possible purchases if it does not meet Graham’s rigorous criteria? The answer is a resounding no, so long as the speculative stock holds an adequate risk vs. reward scenario and the investor recognizes the fact the stock is speculative in nature and fails the safety of principal clause. In other words, losing money is a distinct possibility, thus the investor must not commit a high percentage of his investable funds into the holding. Further, it would behoove the investor to hold a small basket of speculative equities in order to spread his risk.
Let’s suppose that an investor commits 20 percent of his holdings in speculative overlays, in the form of five equities. Say a year later, one of the stocks results in a total loss, three stay about even and one stock triples in value. Despite the fact that one stock is now worthless (except as a loss carry forward), the speculative portfolio has netted a positive gain of 20% assuming that the purchaser bought equal amounts of each of the equities. This type of strategy can make sense, particularly during periods when the overall valuations of the stock market are stretched resulting in few candidates which present themselves in terms of Graham’s classic definition of an investment operation. Conversely, intelligent speculation holds much less merit during periods of excessive market pessimism. During those periods, stocks which hold safety of principal (in the long term) as well as an adequate return frequently present themselves in abundance.
Committing Errors in Security Analysis
The two most common errors that investors commit when analyzing stocks consist of:
Failing to anticipate a social, legislative or economic change which will permanently diminish the future earnings power of a business
Purchasing a low-quality business that is temporarily enjoying an earnings influx due to favorable business conditions, or the introduction of a new product or service that contains no durable competitive advantage
In my opinion, Graham’s most important quote comes from chapter 20 of The Intelligent Investor:
“Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”
Anyone who watches TV has probably seen a commercial featuring garden hoses that roll up automatically after the water is turned off. As soon as the hoses became popular, a bevy of different manufacturers entered the market and had a highly detrimental effect on the sales of the original producer. I had such an experience with my tiny home improvement business in the late 1990s.
I used to attend the spring and fall home shows at Omaha’s Civic Auditorium on a regular basis. One winter, I had an inspiration which I decided to unveil at the upcoming spring show. I contacted a window distributor who was introducing a new line of thermo-efficient vinyl windows, which sold at a significant discount to the price I had been paying for my windows. At that time, “lifetime” vinyl replacement windows were commonly sold at prices between $400-1,000 per unit including installation. Furthermore, no booth at the home show ever advertised any price per window; rather remodeling companies would tell the potential customer that a representative would need to measure the windows to determine a price. The idea was to set a lead, get into the house, and let the salesman work his closing magic. The practice was nearly universally accepted and the sole purpose of the home show booth was to acquire leads which the vendors hoped would turn into window sales at some point down the line.
As it turns out, many of the attendees had already priced their windows numerous times and many found the price to be exorbitant. After making a few simple calculations, I determined that I could sell the new line installed at a price of $299 and still record nearly a 50% gross margin. I discussed my strategy with the distributor and he agreed to provide a lifetime warranty on service (although I was skeptical about the claim) and pay for a large sign to hang prominently in my booth which boldly proclaimed: Lifetime Double Pane Windows with LowE/Argon $299 Installed.
The response to the sign was overwhelming and I sold hundreds of windows following the show where normally I would have been lucky to sell several dozen. During the home show I noticed another thing, the sign also drew the curiosity and sometimes the ire of salesmen and managers from other companies who resented my “lowball” tactics.
When the fall home show arrived, I eagerly hung my sign but this time the response was decidedly underwhelming. Upon walking down the aisle, I noticed a prominently displayed sign from a much larger remodeling company which read: Lifetime Triple Pane Windows with LowE/Argon $299 Installed. My revenue bonanza had ended abruptly only a few months after it had started. It appeared that Graham fellow might have known something after all, in the regard to the durability of earnings for my low-quality home improvement company.
The Demise of Ak-Sar-Ben
At this point I return to the saga of Ak-Sar-Ben, once a perennial top-ten thoroughbred race track which rapidly degenerated into a money-losing operation following a change in gambling economics. In 1985, the track recorded a record average mutual handle of nearly 1.8 million per day. One year later, dog racing opened for across the river in Council Bluffs, Iowa, destroying Ak-Sar-Ben’s Midwest gambling monopoly which had lasted for decades which in turn, prompted a terminal decline in wagering at the race course. Ten years later, Ak-Sar-Ben permanently closed its doors to horse racing, its demise was hastened by the approval of slot legislation by the Iowa Racing Commission and the failure of Nebraska to approve the gaming devices at their tracks.
Ak-Sar-Ben’s declining revenues were a classic example of the boilerplate warning: past returns may not be indicative of future results. As it turned out, the only reason the race course thrived was due to the fact it was the only legitimate gambling venue in a radius which spanned hundreds of miles. When the legislative-enforced moat was breached, all the glorious past results became as worthless as a Confederate dollar. The lesson is quite clear: When investing in the economic goodwill or intangible assets of a business, an investor must be certain that the circumstances which support the franchise are not ephemeral in nature. Otherwise, the business is worth no more than the sum of its tangible assets and probably a significant amount less should significant competition enter into its arena. Thus assessing margin of safety requires that an investor anticipate future business risk rather than merely examining the past results of a business. Investors in Ma Bell and all her babies found out that lesson in spades when a superior technology referred to as the cellular phone entered the market in the late 1980s.
Avoiding Pitfalls and Assessing Risk
While no investor is infallible, one needs to think along the lines of an insurance actuary when evaluating the risk/reward scenario of an investment. It is imperative to construct a list of possible events which could destroy the value of the investment and hamstring its future earnings power.
In the case of Ak-Sar-Ben, it would have been relatively easy to prognosticate its eventual downfall; however in the case of the rapid decline in the newsprint businesses or the meteoric rise in online buying and its detrimental effects on traditional brick and motor businesses, the inevitable was not so easy to visualize. Further, relatively few value minds successfully handicapped the true risk of investing in behemoth financial institutions prior to the credit crisis, although many of them were acutely aware of the rapidly expanding housing bubble which was fueling the earnings of most of the companies in the financial sector.
In my next addition of “Constructing an Intelligent Investment”, I will review the risk/reward assessment process that I employed prior to investing in some of my larger positions. I hope it will enlighten young investors in regard to the thought process which is essential if one is to develop into a successful value investor.
