This is a good one….
“Davidson” submits:
Value Investors have been long puzzled at the phenomena of society’s readily buying discounted items of every day utility, i.e., gasoline, food, soap and flat panel TVs, while society tends to buy security markets at highs and to sell at lows. Today’s WSJ carries two articles by E.S. Browning,“Small Investors Flee Stocks, Changing Market Dynamics” and “The Herd Instinct Takes Over” which are worth reading. The links which may require a subscription are:
The psychology of buying securities at a discount is does not seem like the same psychology in buying two boxes of Cheerios for the price of one. These two actions seem to differ both quantitatively and qualitatively. The action of acquiring two-for-the-price-of-one of something which one routinely consumes provides one with virtually a doubling of one’s regular sense of value at virtually no risk. The value proposition in the Cheerios case is virtually guaranteed if we are willing to pay the cost. The only risks are that the items may be damaged in transport or in storage at home and become unusable. A transaction of this sort provides an immediate value gain which fits neatly into our sense the value context which we have built over time. We do not view securities in the same context nor do we?
The term “Herd Instinct” pertains to the behavior of animals in herds, flocks, and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events, religious gatherings, episodes of mob violence and even everyday decision making, judgment and opinion forming. Modern psychological and economic research has identified herd behavior in humans to explain the phenomena of large numbers of people acting in the same way at the same time. The German philosopher Friedrich Nietzsche is reported to be the first to critique what he referred to as “herd morality” and the “herd instinct” in human society. A very early reference is the classic paper by Grossman and Stiglitz (1976) that showed that uninformed traders in a market context believe that they can become informed through the price in such a way that it is believed that private information is aggregated correctly and efficiently. In short, many believe in the concept of the “Invisible Hand” which is believed to operate in markets to ensure that prices correctly represent values. The “Invisible Hand” has been a societal belief spanning centuries.
The difference between Value Investors and the rest of society is that Value Investors have a context outside the “Herd Instinct”. Value Investors do not believe in the concept of the “Invisible Hand”. Value Investors rely on the “Invisible Hand” belief and the “Herd Instinct” to find investment opportunities they believe will produce above average investment returns during periods when the majority of investors are panicking. At the center of a Value Investor’s context is knowledge of historical return and market pricing during economic cycles that is contrary to that of the “Herd Instinct”. This is why Value Investors look forward to economic slumps.
Warren Buffett is a well known Value Investor. If one reads Buffett’s Chairman’s letters, he reveals bits and pieces of his investment strategy. Buffett estimates that the SP500’s Earnings grow ~5%-7% over the long term. My studies place the growth rate at ~6.1%. He waits for economic slumps to provide him with discounted prices. A good example is his recent takeover of Burlington Northern (BNI). BNI is expected to rise from a ROE of 19% today to 25% in ~5yrs. Buffett bought considerable stock at 2xBook Value and ~$72shr in 2008 when his puts were exercised. At ~$72/shr Buffett expected a 9.5% return. This is well above Buffett’s long term benchmark. The calculation is simple:
Calculation:
19% ROE/(2xBook Value Purchase Price) = 9.5% cash on cash investment return
If one reads several years of BNI annual reports and various industry reports, then the expectation that BNI may improve its ROE to 25% in ~5yrs is not an expectation that is out of the question. If one then calculates the 5yr forward Book Value and assumes a rise to 25% ROE, it becomes clear that Buffett thinks that he can achieve a significant return on his investment. I have shown in earlier emails how the Market Capitalization Rate (MCR) market benchmark effects market valuation levels. Should inflation remain roughly stable Buffett’s BNI purchase at 2x Book Value today has the potential to move to a range of 5x to 6.25x Book Value with a 25% ROE.
So….following the thought process…Buffett buys at 2x BV…inflation remains controlled…BNI continues its pace of efficiency and produces ROE 25% in 5yrs. Buffett can justify valuing BNI whose Book Value per share which has moved from $35shr to $100shr at $500 to $625 using a MCR in the 5%-4.1% range. Warren Buffett bought BNI in its entirety at $100/shr on Feb 12, 2010. If BNI achieves the expected goals, then in 5yrs BNI Buffett may value the holding at the $500-$625 range. I think he bought this investment cheaply, but investors sold into his offer willingly. When one views investments over history within the context of the MCR, one understands the rationale of Buffett’s purchase of BNI. In my experience many Value Investors have developed investment benchmarks over years of experience. These benchmarks are quite often simple rules of thumb. Value Investors typically do not tell the world what these benchmarks are. Buffett did not either, unless one reads his work very, very carefully.
Most investors do not have the time to develop the deep understanding that come from years of investing experience. Most investors continue to sell with every 200-300pt swing in the Dow Index. They are literally pounded with negative media opinion which views low prices as much more risky than high prices. This is the “Herd Instinct”. It is a visceral uneducated perspective and destructive to investment capital. The belief that Price = Value is what is in essence FAS 157, the infamous Mark-to-Market accounting rule. Unfortunately, what we fail to recognize is that we are all geared to be Value Investors. We just need the necessary information.
It takes considerable self discipline to recognize that what is true about Cheerios also true about stocks and bonds.
The markets remain inexpensive and one is still able to buy-two-for-the-price-of-one (in my perspective)!
Todd Sollivan
http://www.valueplays.net/
“Davidson” submits:
Value Investors have been long puzzled at the phenomena of society’s readily buying discounted items of every day utility, i.e., gasoline, food, soap and flat panel TVs, while society tends to buy security markets at highs and to sell at lows. Today’s WSJ carries two articles by E.S. Browning,“Small Investors Flee Stocks, Changing Market Dynamics” and “The Herd Instinct Takes Over” which are worth reading. The links which may require a subscription are:
The psychology of buying securities at a discount is does not seem like the same psychology in buying two boxes of Cheerios for the price of one. These two actions seem to differ both quantitatively and qualitatively. The action of acquiring two-for-the-price-of-one of something which one routinely consumes provides one with virtually a doubling of one’s regular sense of value at virtually no risk. The value proposition in the Cheerios case is virtually guaranteed if we are willing to pay the cost. The only risks are that the items may be damaged in transport or in storage at home and become unusable. A transaction of this sort provides an immediate value gain which fits neatly into our sense the value context which we have built over time. We do not view securities in the same context nor do we?
Excerpt from “Small Investors Flee Stocks, Changing Market Dynamics”:Actually, the overall context is identical and it is why it is so difficult to invest in stocks when they are down. The context is embedded in the term “Herd Instinct”. While everyone would concur that traveling a little out of the way to save a few cents per gallon of gasoline makes financial and emotional sense, it is very difficult to think of buying depressed securities when the majority are calling them risky with uncertain futures. It is far easier to buy something at a known discount and a known immediate gain within the immediate context of average prices than to risk capital for an uncertain return over an uncertain time horizon with uncertain current risks with uncertain solutions with the potential for additional unexpected negative events. Most people feel the same. It is “Herd Instinct” that controls much of our behavior.
Karen and Roger Potyk, a comfortably retired couple in San Antonio, Tex., had clung to some stock mutual funds despite their anxiety following the financial crisis of 2008. But the renewed market volatility following the “flash crash” of May 6 proved too much to bear.
Karen and Roger Potyk sold the last of their stock mutual funds after May’s market volatility.
“We just didn’t want to put up with it any more,” says Karen Potyk. She and her husband sold the last of their stock holdings on May 20, moving the money to bonds, certificates of deposit and bond-like annuities.
The term “Herd Instinct” pertains to the behavior of animals in herds, flocks, and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events, religious gatherings, episodes of mob violence and even everyday decision making, judgment and opinion forming. Modern psychological and economic research has identified herd behavior in humans to explain the phenomena of large numbers of people acting in the same way at the same time. The German philosopher Friedrich Nietzsche is reported to be the first to critique what he referred to as “herd morality” and the “herd instinct” in human society. A very early reference is the classic paper by Grossman and Stiglitz (1976) that showed that uninformed traders in a market context believe that they can become informed through the price in such a way that it is believed that private information is aggregated correctly and efficiently. In short, many believe in the concept of the “Invisible Hand” which is believed to operate in markets to ensure that prices correctly represent values. The “Invisible Hand” has been a societal belief spanning centuries.
The difference between Value Investors and the rest of society is that Value Investors have a context outside the “Herd Instinct”. Value Investors do not believe in the concept of the “Invisible Hand”. Value Investors rely on the “Invisible Hand” belief and the “Herd Instinct” to find investment opportunities they believe will produce above average investment returns during periods when the majority of investors are panicking. At the center of a Value Investor’s context is knowledge of historical return and market pricing during economic cycles that is contrary to that of the “Herd Instinct”. This is why Value Investors look forward to economic slumps.
Warren Buffett is a well known Value Investor. If one reads Buffett’s Chairman’s letters, he reveals bits and pieces of his investment strategy. Buffett estimates that the SP500’s Earnings grow ~5%-7% over the long term. My studies place the growth rate at ~6.1%. He waits for economic slumps to provide him with discounted prices. A good example is his recent takeover of Burlington Northern (BNI). BNI is expected to rise from a ROE of 19% today to 25% in ~5yrs. Buffett bought considerable stock at 2xBook Value and ~$72shr in 2008 when his puts were exercised. At ~$72/shr Buffett expected a 9.5% return. This is well above Buffett’s long term benchmark. The calculation is simple:
Calculation:
19% ROE/(2xBook Value Purchase Price) = 9.5% cash on cash investment return
If one reads several years of BNI annual reports and various industry reports, then the expectation that BNI may improve its ROE to 25% in ~5yrs is not an expectation that is out of the question. If one then calculates the 5yr forward Book Value and assumes a rise to 25% ROE, it becomes clear that Buffett thinks that he can achieve a significant return on his investment. I have shown in earlier emails how the Market Capitalization Rate (MCR) market benchmark effects market valuation levels. Should inflation remain roughly stable Buffett’s BNI purchase at 2x Book Value today has the potential to move to a range of 5x to 6.25x Book Value with a 25% ROE.
So….following the thought process…Buffett buys at 2x BV…inflation remains controlled…BNI continues its pace of efficiency and produces ROE 25% in 5yrs. Buffett can justify valuing BNI whose Book Value per share which has moved from $35shr to $100shr at $500 to $625 using a MCR in the 5%-4.1% range. Warren Buffett bought BNI in its entirety at $100/shr on Feb 12, 2010. If BNI achieves the expected goals, then in 5yrs BNI Buffett may value the holding at the $500-$625 range. I think he bought this investment cheaply, but investors sold into his offer willingly. When one views investments over history within the context of the MCR, one understands the rationale of Buffett’s purchase of BNI. In my experience many Value Investors have developed investment benchmarks over years of experience. These benchmarks are quite often simple rules of thumb. Value Investors typically do not tell the world what these benchmarks are. Buffett did not either, unless one reads his work very, very carefully.
Most investors do not have the time to develop the deep understanding that come from years of investing experience. Most investors continue to sell with every 200-300pt swing in the Dow Index. They are literally pounded with negative media opinion which views low prices as much more risky than high prices. This is the “Herd Instinct”. It is a visceral uneducated perspective and destructive to investment capital. The belief that Price = Value is what is in essence FAS 157, the infamous Mark-to-Market accounting rule. Unfortunately, what we fail to recognize is that we are all geared to be Value Investors. We just need the necessary information.
It takes considerable self discipline to recognize that what is true about Cheerios also true about stocks and bonds.
The markets remain inexpensive and one is still able to buy-two-for-the-price-of-one (in my perspective)!
Todd Sollivan
http://www.valueplays.net/
