Lessons from Graham: 3 ways you can ‘mar’ your investment returns

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Benjamin Graham, the original Value Investor, is widely regarded as the Dean of Wall Street and not without reason. His fundamental lessons drawn from the early part of the 20th Century remain timeless.

Here is a humble attempt to distill his advice into three fundamental points. There is obviously a helluva lot more to investing; however, assuming simplicity is almost an end in itself in investment success rather than just a means, one can do a lot with just this much.

Forgetting you are a Marginal Investor in the business not the stock

Unless you are a short-term trader (don’t be one!), recognise that you are buying a part of the business. The distinction is important is because it sets a different kind of expectation, which in turn influences returns.

You’ll often hear about a company that is a great business and not a great stock. Over the long-term, this will converge because a stock cannot provide you with a return that is greater than the return the business provides on the invested capital. In the short to medium-term, the stock may under-perform. Such times, assess for yourself:

Is the company growing?

A business derives growth from doing better than its competitors while retaining pricing power in the market. This will have many underlying factors within it, which are worth analysing since growth is not an outcome of chance but purpose. Revenue, market share, price growth, and volume growth are some of the indicators of how well the business is doing at a fundamental level. Some of these numbers are easy to come by and analyse, others require some elementary effort.

If so, is the growth improving return on capital?

Growth for the sake of it translates into poor return on capital. Whatever cash a business needs to fund growth with is cash that isn’t flowing to its owners. Hence, stellar top and bottom line growth may not mean much if excessive capital is being used to generate it.

The above questions preoccupy management and promoter time. There is no reason why they shouldn’t preoccupy you, the public shareholder, too with some sense of proportion.

Paying obeisance to Mr.Market

Graham explained the working of the stock market through an allegory. According to him, Mr.Market is a co-owner of the business alongside you. He comes to work every day bids to buy what you own when he is wildly optimistic or asks for a price to sell you what he owns when he is very pessimistic. His ‘bids’ and ‘asks’ fluctuate every day, minute, and second, day after day, reflecting his estimate of the business’s value even though nothing in the underlying business fundamentals has changed in that time. Each time you turn Mr.Market away, he comes back with a revised offer, influenced by expectations, biases, opinions, or even his mood of the day.

This allegory is useful in understanding the role of emotions in market price movement. Theories about market efficiency went full circle from Mr.Market to the Efficient-market Hypothesis and back to a recognition of the role of emotions and animal spirits in pricing. Perhaps the best endorsement of this approach comes from Warren Buffett who regards this as “the best part of the best book [Graham’s The Intelligent Investor] on investing ever written”.

Takeaway for the investor: market price is a reflection of Mr.Market’s mood of the moment, not the business’s value.

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Disregarding Margin of Safety

Margin of Safety (MoS) in investing refers to the proportion by which Mr.Market’s price is lower than your estimate of what this business is worth. MoS is something you naturally want to maximise. But why?

MoS takes care of all the guesstimation, assumptions, hole-plugging, and bypassing that are a fundamental part of trying to assess business value. The best value investors will tell you that in investing it is far better to be approximately right than precisely wrong. More mistakes have likely been made in the pursuit of precision than in making educated guesses using organised common sense. The reason is obvious: the false confidence that comes from precision leads to bigger bets and bigger mistakes. MoS then takes care of what may be important but not knowable.

Think of it this way: if you are driving a truck weighing 9 tons and need to cross a bridge, you will confidently go over it if the load bearing weight of the bridge is 10 tons. More so if the bridge spans a 2 feet deep gap. But would you if it spanned the Chenab River?

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Think like an owner, ignore fluctuations, and keep risk in the foreground – with this, you may not see big home runs but you will make fewer mistakes. Long-term investment success, despite what many will tell you, is about the latter rather than the former.

 

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