Someone who reads my articles sent me this comment about yesterday’s article called “What Ben Graham’s Mr. Market Metaphor Really Means”: I fully agree that an investor needs to make an independent assessment of the value of a company before investing, any investment decision needs to be driven by a comparison between price and value and nothing else.
However...
I do believe that it makes sense to try and understand market psychology and motivations of other market participants. How can you intelligently take advantage of market psychology if you don't understand what is causing market fluctuations?
From the way you describe the 2000 examples for J&J and Village, it's clear that you have a rough idea why the market is overly pessimistic, giving you a decent opportunity to take advantage, yes, the basic condition to invest is to establish that there is a comfortable margin of safety between price and value, but I think it definitely helps if you can understand why a security is mispriced by the market. If you can't figure out a reasonable explanation, it might even be better to pass and not take an unintelligent risk because 9 out of 10 times the market is not stupid and there is a very valid reason why a security is priced the way it is...”
I understand the point. But I think having a reasonable explanation for why a stock is mispriced works better in theory than in actual practice. In fact, the best stocks I’ve ever bought were stocks where it was hardest for me to find a reasonable explanation.
The category of stocks that tends to give you really good returns is what I’ll call “perfectly decent” companies selling for absurd prices. You notice the absurd price right away. Then you check out the company to see if it’s a fraud, has a single product that’s some fad, is about to lose a customer that makes up 40% of sales, etc. You check the long-term record. And then you notice – hey, this company really doesn’t have a history of doing worse than American business generally. Why is it so cheap?
Now, at this point I can come up with plausible reasons. We all can. We humans have story minds. I tell you a stock is cheap and you start spinning reasons for why it might be cheap. We don’t like facts to just sit there. We want to justify them. Connect them.
If you’re watching a movie and one character obviously hates another and this goes on for even 10 seconds – you’re already looking for a back story. That’s just the way we are.
And we’re creative. So we can do it. We can always imagine a back story. We can even make it sound plausible.
But stocks aren’t stories. We don’t get paid for telling the most coherent and reasonable explanation of the facts. We get paid when we see the facts, understand their meaning in terms of a buy/sell choice, and act on that choice.
Where I think understanding why a stock is mispriced – and worrying about it – doesn’t work very well is in the kinds of situations Warren Buffett mentioned to the University of Kansas students (and others) when discussing how he could make 50% a year:
“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.”
Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.”
Now, you could argue that when Warren Buffett explains a situation like Sanborn Map, Commonwealth Trust, American Express, etc., this includes an explanation of why the stock is disliked. For example, American Express had a big potential liability due to the Salad Oil Scandal. Technically, they were a joint stock company. Therefore, mutual funds did not want to be exposed to unlimited liability. Sanborn Map was valued on an earnings basis rather than a cash and earnings basis. Commonwealth Trust was a bank that didn’t pay a dividend. Union Street Railway was disliked as a permanently declining business.
The problem is that Union Street Railway really did have 3 times as much in investments per share as their stock price. And this was quite public. The Moody’s Manual entry for the company included a specific note pointing out Union Street Railway’s special fund.
If we think that being a declining business is explanation enough for other investors neglecting a stock – yes, we’re offering an explanation. But our explanation seems to be that investors sometimes lack the reading and math skills of a six year old. It was one sentence. With one math problem.
I don’t believe that. What I believe is that investors never really paid attention to Union Street Railway as a stock or to the fact it had $100 in investments. They either saw Union Street Railway (oddly, a bus company) and said: “Eww, bus company. Gross.” Or they saw the balance sheet note in Moody’s and thought: “Yeah. But what good is cash. I want earnings. Earnings are what makes a stock go up.”
I don’t have a better explanation for why investors let a stock trade at one-third of its cash value. And I don’t think those two explanations tell me anything the $100 in cash didn’t already tell me. The stock is cheap. That’s all I need to know.
I suppose I could lay out the same sorts of iffy arguments for stocks I’ve bought. Omnicom (OMC, Financial) and IMS Health were bought during a stock market panic. And a panic can explain anything. Advertising was going to be weak for a couple years in a global recession. People thought this wasn’t the time to buy an advertising company. IMS Health was a healthcare company while healthcare reform was being discussed. Some Senators brought up things they didn’t like about IMS Health in regards to patient privacy. And one state actually passed legislation that could’ve harmed IMS Health. But none of this seemed all that material to the stock. And it’s kind of hard to see how people would actually believe it was material to the company’s business. It’s not like they were debating the fees IMS Health could charge (the way credit card companies, banks, etc., were being discussed).
Honestly, I think a lot of people stopped paying attention to the stock. In the middle of a panic, in the middle of hating healthcare stocks generally, in the middle of all that – a lot of people who might normally appreciate a business with that kind of wide moat trading at that kind of P/E didn’t even take a moment to notice the stock.
I actually think my “not paying attention” explanation makes more sense than thinking that people carefully considered the prospects for legislative changes, spending cuts by big drug companies, etc., and decided the stock’s low P/E was justified by its gloomy prospects.
At least I hope so. Because when I bought shares of IMS Health, I felt pretty sure the guy on the other side of that trade had to know more about the future of the pharmaceutical industry – because it’s hard to imagine a topic I know less about than the future of pharmaceuticals.
I could go down the list for each company that I thought was an especially oddly valued stock. For Birner Dental (BDMS, Financial), it’s possible people were paying more attention to earnings per share and dividends than EBITDA and share buybacks. For Bancinsurance, the company’s top management was under SEC investigation. For George Risk (RSKIA, Financial), it was a combination of not really cheap on a P/E basis and just barely cheap on a cash basis – and it was connected to homebuilding.
I could go on like that. But I’m not sure I understand why knowing anything about the perceptions of others actually helps my own investment decisions. I’m also not sure the reasons I’ve offered for the cheapness of those stocks are actually the reasons anybody else had for selling the stock, not buying it, etc. In fact, I think those are just plausible reasons I made up.
But that’s not the problem with wanting to know why a stock is cheap. The problem is how that knowledge – or the quest for it – directs your attention. And attention is the scarcest resource an investor has.
Once you know what somebody else’s perception is, you try to either prove or disprove that perception. In essence, I see the problem of thinking about market sentiment – of worrying about the Keynesian beauty contest – as being like one of those optical illusions. Like the duck-rabbit illusion. In fact, this concern of mine is one of the reasons why I’ve suggested investors read Kuhn.
They often talk about some past period – like the 1920s or 1950s – with a total misunderstanding of what people were looking for in a stock back then. Of how they thought about stocks. Of what they thought stocks were. This isn’t a misanalysis of the facts. It’s a misclassification.
When Ben Graham started on Wall Street there was none of this “Stocks for the Long Run” stuff. There was no talk of asset classes. There were investments called bonds. And there were speculations called stocks. And it was heresy when Ben Graham basically said a cheap stock is a better investment than an expensive bond.
You become a bad financial historian when you confuse your own perceptions – your own way of classifying stocks and noting the aspects of a stock – with how people really thought about stocks back then.
In the same way, I think you become a bad investor when you let Mr. Market see stocks for you. You limit yourself to agreeing or disagreeing with the arguments out there. Instead, the best answer may not be to agree or disagree with specific points about a stock. It may be to have a totally different concept – to see the stock in an entirely different way than they do.
This is why I keep telling people to read "Hidden Champions." I keep pushing that book on people, because whenever someone talks to me about a great business – it’s a big business. There are hundreds of great, little public companies out there. But most value investors approach a big company thinking “moat.” And a small company thinking “price” or “growth.” They get focused on one way of seeing a company and can’t force themselves to see there is an alternative pattern in there.
My problem with paying attention to other people’s feelings about a stock – to think about how they see it – is that you then try to analyze the stock in those terms. It’s like if someone shows you the duck-rabbit illusion and talks about what an ugly duck it is. Now, maybe it is a very ugly duck. But maybe it is also a very pretty rabbit. Yet because you are now thinking in terms of a duck – analyzing a duck, using the language you would use when discussing a duck – your entire perspective on the image has been directed toward this idea of assessing the beauty or ugliness of the duck. Not the rabbit. The rabbitness of the drawing will not even enter into your analysis. And so while debating the ugliness of the duck – staking out your well reasoned position either pro or con – you are in fact making yourself blind to the rabbit.
You are patting yourself on the back for your incisive analysis of that ugly duck without once realizing you missed the opportunity to buy a beautiful rabbit.
There is never just one way to see a stock. There is not one model to use when looking at all businesses. It is not merely a matter of assessing a pattern as we see it. Rather, we must first look for the pattern and then see the extent to which the case we are looking at fits our idea of that pattern.
So, the great danger in participating in a debate with the market is that you have let the market choose the topic of that debate. If the market thinks that George Risk is a lousy net-net that isn’t worth the cash it is holding, then I’m likely – if I take market sentiment as one of my starting points – to analyze George Risk in those terms.
That would be a mistake. If you actually look at George Risk – it’s a good business. So, if you go into the situation using the toolkit you normally bring to analyzing net-nets, you are really gouging out one of your analytical eyes. You are blinding yourself to an obvious reality because you started by letting the market tell you whether it was a rabbit or a duck. You said: “Oh, this is a net-net.” And you didn’t ask if something can be a net-net and something else at the same time.
And this is not just some theoretical issue I raise. I see it all the time. The way in which someone finds a stock – the “class” of investment opportunity they first put it in – determines their first impression of the stock, the tools they use to analyze the stock, the checklists, models, examples, etc., they first think of. In a very real way, they are defining the stock before they’ve really even met the stock. They are saying, “Fine, the market wants to talk about this stock as a turnaround, a busted growth stock, a possible fraud, etc. I will engage the market on those terms."
Which is idiotic. Because while you can think of a stock as a bet on some future event’s probability and the payoff should that event occur – you don’t have to. That’s the whole Mr. Market idea. It’s optional. You have the right but not the obligation to buy or sell a stock at the market price. That’s the one advantage a public company has over a private company. A public company is a private company with buy/sell options attached.
Well, you also have analytic options. The whole point of having a pantheon of models up there in your brain is so you can see a lot of different stocks a lot of different ways. But if you start thinking about what other investors think about a stock you’re analyzing – now you’ve got a limited vocabulary.
I mean, when I talk about stocks I talk about pixie dust businesses and demon dust businesses and moats and reliability and compartments of defense. I’m bringing in stuff I’ve read in books like "Hidden Champions" which isn’t even technically an investment book. Can I really believe other investors use the same words and see the same business patterns I see?
If you and I have different models in our heads, I can always apply my models to my thinking about anything in the world. But I can’t apply my models to your thinking. This isn’t meant to be a brain teaser.
I’m seriously saying there will be times when I see a stock a certain way and really can’t say whether others are capable of seeing the stock that way.
So, I think we really exaggerate this idea of a buyer and a seller taking opposite sides in some discourse. There’s nothing that says buyers and sellers aren’t usually talking past each other.
There is nothing that says that a buyer and seller of a stock must be taking opposite sides of a bet on some event. In fact, there is nothing required of the buyer and seller except disagreement on the issue of whether or not to hold the stock.
But that is a complex issue. It is like if we say that you and I both love some movie or both hate some movie. There is no need for us to necessarily agree on even a single aspect of the movie – we need only agree that the whole package is good or bad. Unless we break down the movie point by point, we will never know that we have totally different views of the same movie. We’ll think we’re in agreement.
That’s the problem I see with taking the approach that there is a definite issue or a dozen definite issues to be decided with a stock. I think that goes against the kind of work that has been successful for folks like Buffett and Munger. The real issue in stock analysis is usually not better understanding the probability of some outcome, the magnitude of the gain or loss that will occur, the timing, the causal chain, etc. The real issue is seeing the same stock in a different way.
If you look at a stock like Bancinsurance, the entire extent to which I “disagreed” with the market – to the extent there even was a market – was with the idea that the stock was worth less than book value. I knew it was an insurance stock. I knew that many insurers do trade below book value. The market and I were in total agreement on those points. Where we differed was that I believed that an insurer that had posted a combined ratio below 100 in 28 of the last 30 years, that had averaged a combined ratio in the mid to low 90s over almost any period you could pick, and that had earned a 10% or better return on statutory surplus even in a decade with a giant loss in an unrelated line, was a stock that could earn the same return on its equity that many other non-financial companies would earn.
So I actually don’t think there would be many points of disagreement between me and other folks who looked at the stock. If there was a key disagreement it was simply that they saw a duck while I saw a rabbit. That they saw an insurance company. While I saw a company that could reliably earn 10% on its equity. For me, once a company can reliably earn 10% on its equity, it should be worth book value as long as its financial condition is adequate. If that 10% return on equity is going to be reliably earned and it is going to be done without taking on unusual risks – then that is a stock that is worth book value. Because what determines a stock’s value relative to book value is the return the company can get on its book value not the industry it belongs to.
I think this is a very important point. But it’s one that’s very, very hard to talk about. People will see Warren Buffett – after knowing about a stock for so long and having it sometimes trade at even lower prices – suddenly buy that stock. And this will baffle them. And so they will go hunting for what has changed. What makes this the right moment to buy that stock? Why didn’t he buy it before but he is buying it now? Certainly, there has been an objective change in the situation.
Very often the answer is no.
He says this. He says it’s an accumulation of knowledge over time. But people want to see some explanation for a changed belief on some specific issue instead of a bigger shift of perspective – a different way of seeing a stock.
You can’t explain a lot of good stock purchases based on some belief change. Buy decisions aren’t just some reaction to something out there in the real world environment. They are a reaction to something in your own subjective mental environment. They are a reaction to a new way of seeing a stock. Where once you saw a duck now you see a rabbit. This is such a common phenomenon in investing specifically and analysis generally that we all know what it feels like to have an analytical epiphany.
Yet we still talk about stocks as if we are engaged in simple, rational choice. As if the issue to be debated is settled and we are either “pro” or “con”, believers or disbelievers in the ability of management to turn some company around, or the fate of brick and mortar retailing in an online world, or what will become of Blackberry.
But very often that is not the real battleground. It’s not like we are just sitting there struggling with probabilities. What we are struggling with is understanding. We are struggling with the need to shuffle through our pack of known patterns and find something that is at least congruous with what we are seeing. We are looking for a way to see a stock as much as we are looking at whether what we see is good or bad.
One of the biggest mistakes people make with their best ideas is failing to realize exactly what they have.
I just read a really good example of this from Nate over at Oddball Stocks:
Adams Golf Gets a Buyout and Other Net-Net Thoughts
Adams Golf (ADGF, Financial) was a net-net. It got bought out by Adidas. By the way, it’s not the only net-net to get bought out this year. Swank (SNKI, Financial) was also a net-net that looks like it’s going to be bought out. Last I heard, they received an alternative proposal during their “go shop” period and haven’t acted on it. The Ben Graham: Net-Net Newsletter’s model portfolio doesn’t own either stock. Though we do own another net-net where a company in the same industry bought a block of shares. Who knows what that means. But clearly net-nets sometimes attract control buyers.
Actually, in my own experience, it’s not as common as people think for a net-net just to rise to NCAV over time and for you to get paid that way. That’s always what people imagine. That there’s this magical number called NCAV pulling the stock toward it. And why net-net investors buy net-nets. Because we believe in the solidity of those receivables, inventory, etc. I really don’t. Actually, I like to think of NCAV as being a marker of cheapness – not a source of value. No one expects the company to actually liquidate at NCAV. People ask me about doing liquidation value estimates and I usually tell them don’t bother. Unless you think the company is actually going to liquidate – why do you need to know what inventory would be worth in a fire sale? All you need to know is that NCAV is an absurd price for a company. It’s a price a 100% buyer would never be offered. So, if the company survives, and strings together a good year or two the CEO or a competitor or whoever will make a buyout offer. Or the stock will actually start posting good earnings and will trade based on its P/E ratio (which is often much, much higher than NCAV).
My point is that the first critical decision you make when analyzing a net-net is how you classify the stock. Personally, I think it’s important to try to analyze the business as best as possible apart from its net current asset value. Remember, the cheapness of a net-net is not in doubt. You know the stock is cheap the second you see the price is below net current assets. So, I think it’s a mistake to obsess over the exact cheapness of a clearly cheap stock. A net-net is cheaper than something like 95% of all public companies. That’s cheap enough. In fact, while the Ben Graham Net-Net Newsletter does show the obligatory chart of current assets and book value – that’s not what I think about when I look at a net-net. I think about the business and the cash. And that’s really it. A lousy business with all the receivables and inventory in the world is not something I’d be interested in – because that’s usually the last thing a buyer wants.
But that’s how a lot of net-net analysis begins. The author actually shows you the receivables, the inventory, etc. in painstaking detail. The problem with that is the possibility that you are seeing the duck so clearly you are missing the rabbit.
The most exciting opportunity in the world is to be offered a good business at a bad business price. But I don’t know many people who just sit down with a list of net-nets and try to sort them from the highest quality business to the lowest quality business. I think that’s because they are locked into seeing net-nets as net-nets.
But a net-net is just a stock selling for a certain price.
To the extent the market prices stocks right, there will be a tendency for the business quality of net-nets to be very poor. But to the extent the market prices stocks right, you’ll tend to not make any money picking stocks. So, I think it’s kind of a weird decision to defer to the market on how you classify a stock.
That’s the real risk with worrying about what the market thinks is wrong with a stock. It can end up being a form of self-induced misdirection. Sometimes certain aspects of an investment are so obvious they can only be hidden by directing your attention to a separate aspect of the stock.
It’s very important what you pay attention to. In fact, how you divide and direct your attention is one of the most important parts of investing.
And I think it’s a huge mistake to let the debate other people are having about a stock be the reason why you focus in on some particular aspect of a stock.
It’s best to come to a stock clean. The ideal situation is one where you can analyze the business before you even know the price of the stock. In the modern world, that’s extremely rare outside of spin-offs. We are bombarded with stock quotes that we can’t just forget when we pick up the 10-K.
I know what price people out there are buying and selling their shares of Wal-Mart at. And I know that knowing that is biasing me. And I can turn off the computer and sit down with the 10-K – but I can’t erase that number in my head. I can’t scrub that bias from my brain. It’s going to rub off on my estimate of what Wal-Mart is worth.
And that’s without me worrying about why people are selling shares of Wal-Mart at that price. It’s bad enough I have to know there are willing sellers at that price. If I knew their reasoning too – I’m not sure I’d be able tell which thoughts rattling around in my head were my own and which I plucked from the echo chamber.
It’s bad enough that we can’t quite insulate ourselves as well as Ben Graham’s Mr. Market metaphor recommends we do.
We don’t need to look deeper into market clues. Those clues already pose the greatest risk of biasing our analysis.
Thinking about what other investors are thinking is as far as you can go in the opposite direction of Ben Graham’s Mr. Market metaphor.
It’s using the market to instruct you. Which is one of the biggest investment mistakes you can make.
Ask Geoff a Question about Mr. Market
Check out the Ben Graham: Net-Net Newsletter
Check out the Buffett/Munger Bargain Newsletter
However...
I do believe that it makes sense to try and understand market psychology and motivations of other market participants. How can you intelligently take advantage of market psychology if you don't understand what is causing market fluctuations?
From the way you describe the 2000 examples for J&J and Village, it's clear that you have a rough idea why the market is overly pessimistic, giving you a decent opportunity to take advantage, yes, the basic condition to invest is to establish that there is a comfortable margin of safety between price and value, but I think it definitely helps if you can understand why a security is mispriced by the market. If you can't figure out a reasonable explanation, it might even be better to pass and not take an unintelligent risk because 9 out of 10 times the market is not stupid and there is a very valid reason why a security is priced the way it is...”
I understand the point. But I think having a reasonable explanation for why a stock is mispriced works better in theory than in actual practice. In fact, the best stocks I’ve ever bought were stocks where it was hardest for me to find a reasonable explanation.
The category of stocks that tends to give you really good returns is what I’ll call “perfectly decent” companies selling for absurd prices. You notice the absurd price right away. Then you check out the company to see if it’s a fraud, has a single product that’s some fad, is about to lose a customer that makes up 40% of sales, etc. You check the long-term record. And then you notice – hey, this company really doesn’t have a history of doing worse than American business generally. Why is it so cheap?
Now, at this point I can come up with plausible reasons. We all can. We humans have story minds. I tell you a stock is cheap and you start spinning reasons for why it might be cheap. We don’t like facts to just sit there. We want to justify them. Connect them.
If you’re watching a movie and one character obviously hates another and this goes on for even 10 seconds – you’re already looking for a back story. That’s just the way we are.
And we’re creative. So we can do it. We can always imagine a back story. We can even make it sound plausible.
But stocks aren’t stories. We don’t get paid for telling the most coherent and reasonable explanation of the facts. We get paid when we see the facts, understand their meaning in terms of a buy/sell choice, and act on that choice.
Where I think understanding why a stock is mispriced – and worrying about it – doesn’t work very well is in the kinds of situations Warren Buffett mentioned to the University of Kansas students (and others) when discussing how he could make 50% a year:
“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.”
Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.”
Now, you could argue that when Warren Buffett explains a situation like Sanborn Map, Commonwealth Trust, American Express, etc., this includes an explanation of why the stock is disliked. For example, American Express had a big potential liability due to the Salad Oil Scandal. Technically, they were a joint stock company. Therefore, mutual funds did not want to be exposed to unlimited liability. Sanborn Map was valued on an earnings basis rather than a cash and earnings basis. Commonwealth Trust was a bank that didn’t pay a dividend. Union Street Railway was disliked as a permanently declining business.
The problem is that Union Street Railway really did have 3 times as much in investments per share as their stock price. And this was quite public. The Moody’s Manual entry for the company included a specific note pointing out Union Street Railway’s special fund.
If we think that being a declining business is explanation enough for other investors neglecting a stock – yes, we’re offering an explanation. But our explanation seems to be that investors sometimes lack the reading and math skills of a six year old. It was one sentence. With one math problem.
I don’t believe that. What I believe is that investors never really paid attention to Union Street Railway as a stock or to the fact it had $100 in investments. They either saw Union Street Railway (oddly, a bus company) and said: “Eww, bus company. Gross.” Or they saw the balance sheet note in Moody’s and thought: “Yeah. But what good is cash. I want earnings. Earnings are what makes a stock go up.”
I don’t have a better explanation for why investors let a stock trade at one-third of its cash value. And I don’t think those two explanations tell me anything the $100 in cash didn’t already tell me. The stock is cheap. That’s all I need to know.
I suppose I could lay out the same sorts of iffy arguments for stocks I’ve bought. Omnicom (OMC, Financial) and IMS Health were bought during a stock market panic. And a panic can explain anything. Advertising was going to be weak for a couple years in a global recession. People thought this wasn’t the time to buy an advertising company. IMS Health was a healthcare company while healthcare reform was being discussed. Some Senators brought up things they didn’t like about IMS Health in regards to patient privacy. And one state actually passed legislation that could’ve harmed IMS Health. But none of this seemed all that material to the stock. And it’s kind of hard to see how people would actually believe it was material to the company’s business. It’s not like they were debating the fees IMS Health could charge (the way credit card companies, banks, etc., were being discussed).
Honestly, I think a lot of people stopped paying attention to the stock. In the middle of a panic, in the middle of hating healthcare stocks generally, in the middle of all that – a lot of people who might normally appreciate a business with that kind of wide moat trading at that kind of P/E didn’t even take a moment to notice the stock.
I actually think my “not paying attention” explanation makes more sense than thinking that people carefully considered the prospects for legislative changes, spending cuts by big drug companies, etc., and decided the stock’s low P/E was justified by its gloomy prospects.
At least I hope so. Because when I bought shares of IMS Health, I felt pretty sure the guy on the other side of that trade had to know more about the future of the pharmaceutical industry – because it’s hard to imagine a topic I know less about than the future of pharmaceuticals.
I could go down the list for each company that I thought was an especially oddly valued stock. For Birner Dental (BDMS, Financial), it’s possible people were paying more attention to earnings per share and dividends than EBITDA and share buybacks. For Bancinsurance, the company’s top management was under SEC investigation. For George Risk (RSKIA, Financial), it was a combination of not really cheap on a P/E basis and just barely cheap on a cash basis – and it was connected to homebuilding.
I could go on like that. But I’m not sure I understand why knowing anything about the perceptions of others actually helps my own investment decisions. I’m also not sure the reasons I’ve offered for the cheapness of those stocks are actually the reasons anybody else had for selling the stock, not buying it, etc. In fact, I think those are just plausible reasons I made up.
But that’s not the problem with wanting to know why a stock is cheap. The problem is how that knowledge – or the quest for it – directs your attention. And attention is the scarcest resource an investor has.
Once you know what somebody else’s perception is, you try to either prove or disprove that perception. In essence, I see the problem of thinking about market sentiment – of worrying about the Keynesian beauty contest – as being like one of those optical illusions. Like the duck-rabbit illusion. In fact, this concern of mine is one of the reasons why I’ve suggested investors read Kuhn.
They often talk about some past period – like the 1920s or 1950s – with a total misunderstanding of what people were looking for in a stock back then. Of how they thought about stocks. Of what they thought stocks were. This isn’t a misanalysis of the facts. It’s a misclassification.
When Ben Graham started on Wall Street there was none of this “Stocks for the Long Run” stuff. There was no talk of asset classes. There were investments called bonds. And there were speculations called stocks. And it was heresy when Ben Graham basically said a cheap stock is a better investment than an expensive bond.
You become a bad financial historian when you confuse your own perceptions – your own way of classifying stocks and noting the aspects of a stock – with how people really thought about stocks back then.
In the same way, I think you become a bad investor when you let Mr. Market see stocks for you. You limit yourself to agreeing or disagreeing with the arguments out there. Instead, the best answer may not be to agree or disagree with specific points about a stock. It may be to have a totally different concept – to see the stock in an entirely different way than they do.
This is why I keep telling people to read "Hidden Champions." I keep pushing that book on people, because whenever someone talks to me about a great business – it’s a big business. There are hundreds of great, little public companies out there. But most value investors approach a big company thinking “moat.” And a small company thinking “price” or “growth.” They get focused on one way of seeing a company and can’t force themselves to see there is an alternative pattern in there.
My problem with paying attention to other people’s feelings about a stock – to think about how they see it – is that you then try to analyze the stock in those terms. It’s like if someone shows you the duck-rabbit illusion and talks about what an ugly duck it is. Now, maybe it is a very ugly duck. But maybe it is also a very pretty rabbit. Yet because you are now thinking in terms of a duck – analyzing a duck, using the language you would use when discussing a duck – your entire perspective on the image has been directed toward this idea of assessing the beauty or ugliness of the duck. Not the rabbit. The rabbitness of the drawing will not even enter into your analysis. And so while debating the ugliness of the duck – staking out your well reasoned position either pro or con – you are in fact making yourself blind to the rabbit.
You are patting yourself on the back for your incisive analysis of that ugly duck without once realizing you missed the opportunity to buy a beautiful rabbit.
There is never just one way to see a stock. There is not one model to use when looking at all businesses. It is not merely a matter of assessing a pattern as we see it. Rather, we must first look for the pattern and then see the extent to which the case we are looking at fits our idea of that pattern.
So, the great danger in participating in a debate with the market is that you have let the market choose the topic of that debate. If the market thinks that George Risk is a lousy net-net that isn’t worth the cash it is holding, then I’m likely – if I take market sentiment as one of my starting points – to analyze George Risk in those terms.
That would be a mistake. If you actually look at George Risk – it’s a good business. So, if you go into the situation using the toolkit you normally bring to analyzing net-nets, you are really gouging out one of your analytical eyes. You are blinding yourself to an obvious reality because you started by letting the market tell you whether it was a rabbit or a duck. You said: “Oh, this is a net-net.” And you didn’t ask if something can be a net-net and something else at the same time.
And this is not just some theoretical issue I raise. I see it all the time. The way in which someone finds a stock – the “class” of investment opportunity they first put it in – determines their first impression of the stock, the tools they use to analyze the stock, the checklists, models, examples, etc., they first think of. In a very real way, they are defining the stock before they’ve really even met the stock. They are saying, “Fine, the market wants to talk about this stock as a turnaround, a busted growth stock, a possible fraud, etc. I will engage the market on those terms."
Which is idiotic. Because while you can think of a stock as a bet on some future event’s probability and the payoff should that event occur – you don’t have to. That’s the whole Mr. Market idea. It’s optional. You have the right but not the obligation to buy or sell a stock at the market price. That’s the one advantage a public company has over a private company. A public company is a private company with buy/sell options attached.
Well, you also have analytic options. The whole point of having a pantheon of models up there in your brain is so you can see a lot of different stocks a lot of different ways. But if you start thinking about what other investors think about a stock you’re analyzing – now you’ve got a limited vocabulary.
I mean, when I talk about stocks I talk about pixie dust businesses and demon dust businesses and moats and reliability and compartments of defense. I’m bringing in stuff I’ve read in books like "Hidden Champions" which isn’t even technically an investment book. Can I really believe other investors use the same words and see the same business patterns I see?
If you and I have different models in our heads, I can always apply my models to my thinking about anything in the world. But I can’t apply my models to your thinking. This isn’t meant to be a brain teaser.
I’m seriously saying there will be times when I see a stock a certain way and really can’t say whether others are capable of seeing the stock that way.
So, I think we really exaggerate this idea of a buyer and a seller taking opposite sides in some discourse. There’s nothing that says buyers and sellers aren’t usually talking past each other.
There is nothing that says that a buyer and seller of a stock must be taking opposite sides of a bet on some event. In fact, there is nothing required of the buyer and seller except disagreement on the issue of whether or not to hold the stock.
But that is a complex issue. It is like if we say that you and I both love some movie or both hate some movie. There is no need for us to necessarily agree on even a single aspect of the movie – we need only agree that the whole package is good or bad. Unless we break down the movie point by point, we will never know that we have totally different views of the same movie. We’ll think we’re in agreement.
That’s the problem I see with taking the approach that there is a definite issue or a dozen definite issues to be decided with a stock. I think that goes against the kind of work that has been successful for folks like Buffett and Munger. The real issue in stock analysis is usually not better understanding the probability of some outcome, the magnitude of the gain or loss that will occur, the timing, the causal chain, etc. The real issue is seeing the same stock in a different way.
If you look at a stock like Bancinsurance, the entire extent to which I “disagreed” with the market – to the extent there even was a market – was with the idea that the stock was worth less than book value. I knew it was an insurance stock. I knew that many insurers do trade below book value. The market and I were in total agreement on those points. Where we differed was that I believed that an insurer that had posted a combined ratio below 100 in 28 of the last 30 years, that had averaged a combined ratio in the mid to low 90s over almost any period you could pick, and that had earned a 10% or better return on statutory surplus even in a decade with a giant loss in an unrelated line, was a stock that could earn the same return on its equity that many other non-financial companies would earn.
So I actually don’t think there would be many points of disagreement between me and other folks who looked at the stock. If there was a key disagreement it was simply that they saw a duck while I saw a rabbit. That they saw an insurance company. While I saw a company that could reliably earn 10% on its equity. For me, once a company can reliably earn 10% on its equity, it should be worth book value as long as its financial condition is adequate. If that 10% return on equity is going to be reliably earned and it is going to be done without taking on unusual risks – then that is a stock that is worth book value. Because what determines a stock’s value relative to book value is the return the company can get on its book value not the industry it belongs to.
I think this is a very important point. But it’s one that’s very, very hard to talk about. People will see Warren Buffett – after knowing about a stock for so long and having it sometimes trade at even lower prices – suddenly buy that stock. And this will baffle them. And so they will go hunting for what has changed. What makes this the right moment to buy that stock? Why didn’t he buy it before but he is buying it now? Certainly, there has been an objective change in the situation.
Very often the answer is no.
He says this. He says it’s an accumulation of knowledge over time. But people want to see some explanation for a changed belief on some specific issue instead of a bigger shift of perspective – a different way of seeing a stock.
You can’t explain a lot of good stock purchases based on some belief change. Buy decisions aren’t just some reaction to something out there in the real world environment. They are a reaction to something in your own subjective mental environment. They are a reaction to a new way of seeing a stock. Where once you saw a duck now you see a rabbit. This is such a common phenomenon in investing specifically and analysis generally that we all know what it feels like to have an analytical epiphany.
Yet we still talk about stocks as if we are engaged in simple, rational choice. As if the issue to be debated is settled and we are either “pro” or “con”, believers or disbelievers in the ability of management to turn some company around, or the fate of brick and mortar retailing in an online world, or what will become of Blackberry.
But very often that is not the real battleground. It’s not like we are just sitting there struggling with probabilities. What we are struggling with is understanding. We are struggling with the need to shuffle through our pack of known patterns and find something that is at least congruous with what we are seeing. We are looking for a way to see a stock as much as we are looking at whether what we see is good or bad.
One of the biggest mistakes people make with their best ideas is failing to realize exactly what they have.
I just read a really good example of this from Nate over at Oddball Stocks:
Adams Golf Gets a Buyout and Other Net-Net Thoughts
Adams Golf (ADGF, Financial) was a net-net. It got bought out by Adidas. By the way, it’s not the only net-net to get bought out this year. Swank (SNKI, Financial) was also a net-net that looks like it’s going to be bought out. Last I heard, they received an alternative proposal during their “go shop” period and haven’t acted on it. The Ben Graham: Net-Net Newsletter’s model portfolio doesn’t own either stock. Though we do own another net-net where a company in the same industry bought a block of shares. Who knows what that means. But clearly net-nets sometimes attract control buyers.
Actually, in my own experience, it’s not as common as people think for a net-net just to rise to NCAV over time and for you to get paid that way. That’s always what people imagine. That there’s this magical number called NCAV pulling the stock toward it. And why net-net investors buy net-nets. Because we believe in the solidity of those receivables, inventory, etc. I really don’t. Actually, I like to think of NCAV as being a marker of cheapness – not a source of value. No one expects the company to actually liquidate at NCAV. People ask me about doing liquidation value estimates and I usually tell them don’t bother. Unless you think the company is actually going to liquidate – why do you need to know what inventory would be worth in a fire sale? All you need to know is that NCAV is an absurd price for a company. It’s a price a 100% buyer would never be offered. So, if the company survives, and strings together a good year or two the CEO or a competitor or whoever will make a buyout offer. Or the stock will actually start posting good earnings and will trade based on its P/E ratio (which is often much, much higher than NCAV).
My point is that the first critical decision you make when analyzing a net-net is how you classify the stock. Personally, I think it’s important to try to analyze the business as best as possible apart from its net current asset value. Remember, the cheapness of a net-net is not in doubt. You know the stock is cheap the second you see the price is below net current assets. So, I think it’s a mistake to obsess over the exact cheapness of a clearly cheap stock. A net-net is cheaper than something like 95% of all public companies. That’s cheap enough. In fact, while the Ben Graham Net-Net Newsletter does show the obligatory chart of current assets and book value – that’s not what I think about when I look at a net-net. I think about the business and the cash. And that’s really it. A lousy business with all the receivables and inventory in the world is not something I’d be interested in – because that’s usually the last thing a buyer wants.
But that’s how a lot of net-net analysis begins. The author actually shows you the receivables, the inventory, etc. in painstaking detail. The problem with that is the possibility that you are seeing the duck so clearly you are missing the rabbit.
The most exciting opportunity in the world is to be offered a good business at a bad business price. But I don’t know many people who just sit down with a list of net-nets and try to sort them from the highest quality business to the lowest quality business. I think that’s because they are locked into seeing net-nets as net-nets.
But a net-net is just a stock selling for a certain price.
To the extent the market prices stocks right, there will be a tendency for the business quality of net-nets to be very poor. But to the extent the market prices stocks right, you’ll tend to not make any money picking stocks. So, I think it’s kind of a weird decision to defer to the market on how you classify a stock.
That’s the real risk with worrying about what the market thinks is wrong with a stock. It can end up being a form of self-induced misdirection. Sometimes certain aspects of an investment are so obvious they can only be hidden by directing your attention to a separate aspect of the stock.
It’s very important what you pay attention to. In fact, how you divide and direct your attention is one of the most important parts of investing.
And I think it’s a huge mistake to let the debate other people are having about a stock be the reason why you focus in on some particular aspect of a stock.
It’s best to come to a stock clean. The ideal situation is one where you can analyze the business before you even know the price of the stock. In the modern world, that’s extremely rare outside of spin-offs. We are bombarded with stock quotes that we can’t just forget when we pick up the 10-K.
I know what price people out there are buying and selling their shares of Wal-Mart at. And I know that knowing that is biasing me. And I can turn off the computer and sit down with the 10-K – but I can’t erase that number in my head. I can’t scrub that bias from my brain. It’s going to rub off on my estimate of what Wal-Mart is worth.
And that’s without me worrying about why people are selling shares of Wal-Mart at that price. It’s bad enough I have to know there are willing sellers at that price. If I knew their reasoning too – I’m not sure I’d be able tell which thoughts rattling around in my head were my own and which I plucked from the echo chamber.
It’s bad enough that we can’t quite insulate ourselves as well as Ben Graham’s Mr. Market metaphor recommends we do.
We don’t need to look deeper into market clues. Those clues already pose the greatest risk of biasing our analysis.
Thinking about what other investors are thinking is as far as you can go in the opposite direction of Ben Graham’s Mr. Market metaphor.
It’s using the market to instruct you. Which is one of the biggest investment mistakes you can make.
Ask Geoff a Question about Mr. Market
Check out the Ben Graham: Net-Net Newsletter
Check out the Buffett/Munger Bargain Newsletter
