“If you can’t explain it simply, you don’t understand it well enough.”
Get your Free
financial review
There is a great deal of redundancy, me-tooism and superfluity in the provision of fund management. There are too many funds out there versus legitimate investor demand. (‘Many are launched, but few are chosen.’) More fund managers should be asked, ‘What’s your big idea ?’
This is an easy question to ask, but a tough question to answer briefly.
The great value investor, Benjamin Graham, did a pretty good job of answering briefly when he wrote, in the very last chapter of ‘The Intelligent Investor’:
“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto: MARGIN OF SAFETY.”
Those three words contain an entire universe of wisdom.
Safety, of course, means different things to different people. And these days, real safety is a tough thing to come by – it may even be impossible.
Nevertheless, here’s our preferred definition. If we first define risk as the likelihood of incurring a permanent loss of capital – the complete and irreversible destruction of your pension fund, for example – then safety has to be the polar opposite. A ‘safe’ investment, or one approaching the characteristic of safety, is one that offers the least foreseeable likelihood of incurring a permanent loss of capital.
To go one stage further in the cause of total clarity, a ‘safe’ investment is one that also accords the investor a meaningful likelihood of retaining his or her purchasing power over the medium and longer term.
A lot of things flow from these simple concepts.
Before we discovered Benjamin Graham, we stumbled upon Daniel Bernoulli. He popped up within the text of Peter L. Bernstein’s 1998 book ‘Against the Gods’: a history of risk that we would recommend to any investment market ‘completist’. Bernoulli, an 18th Century Dutch mathematician and physicist, once remarked:
“The utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.”
It’s a rather dry-sounding statement, couched in very scientific, if not economist-like, language. But when we came across it in 1998 or 1999, while working for Merrill Lynch, it struck us like a lightning bolt.
Bear in mind that, at the time, the world and his wife were stampeding over themselves in their efforts to make obscene profits in internet stocks. Our almost immediate response to Bernoulli was to conclude that “everyone else” was doing it wrong. What would most matter to our clients, being either affluent, wealthy or very wealthy, would not be how much they might make on an investment – but how much they stood to lose. It was during the first dotcom boom that we also came across the wonderful quote by Lord Overstone:
“No warning can save people determined to grow suddenly rich.”
The only real problem with Benjamin Graham’s ‘margin of safety’ observation – and all that naturally flows from it – is that it’s a ‘get rich slow’ or ‘stay rich’ approach. That may have limited appeal to those seeking a sudden and dramatic uptick in their fortunes. But we think every investor has to pursue an approach that sits easily with their own mental furniture. And we’re happy to take a patient view of things. Patience favours the ‘margin of safety’ investor.
Bernoulli’s observation is probably a little closer to conventional wisdom now. It’s difficult for us to say, because we’ve been living with a focus on absolute return investing for so long now it’s difficult to remember having ever invested any other way. But we maintain that Bernoulli still has a claim – among all his other achievements – to be one of the world’s first behavioural economists. The likes of Kahneman and Tversky have more recently confirmed through extensive research the essential truth of what Bernoulli said three centuries ago: human beings, and especially wealthy human beings, hate losing money far more than they enjoy making it. Hence our focus, ever since discovering Bernoulli, on absolute – as opposed to market-relative – investing. We discuss this issue at greater length in this 23rd August interview with Jeremy McKeown.
So this ‘big idea’ isn’t just good for your portfolio, it’s good for your psychological health, too. Like we say, this is genuinely a ‘big idea’ in every sense, because its implications are far-reaching and profound.
Let’s drill a little deeper into some of the implications of ‘margin of safety’.
One of them is that equity investments, for example, can possess certain ‘safe-ish’ characteristics almost entirely independently of the sector they represent or the type of businesses they are. This is what Warren Buffett described as ‘cigar butt’ investments – shares of businesses that had perhaps one last puff in them but which were being given away for free. If you buy shares of any company when those shares are trading at a meaningful discount to that company’s inherent worth / liquidation value / book value, then you don’t even need to worry about the longer term prospects for that company; if it gets wound up, you still expect to make a profit.
But ‘cigar butt’ (a.k.a. ‘deep value’) investing doesn’t interest us so much, just as Buffett himself moved on from it over the course of his career. Value traps are still traps. Instead, we’re more interested in sustainable businesses with a history of superior shareholder returns and highly competent management – but only when the shares of those businesses happen to be on sale, for whatever reason.
Those last three words – “for whatever reason” – are also important. Because one thing that flows from the ‘margin of safety’ approach, at least from our perspective, is that price is far more important than any other subjective characteristic in an investment. Price is in many respects the only thing that matters. A case in point. When we were buying certain mining and commodity company shares within our fund several years ago, a number of highly respected analysts at a data and news company that shall remain nameless (though it rhymes with ‘Roomberg’) told us that we were mad. “Iron ore ? Oh, that sector’s had it. The commodity boom is over.” If we had allowed ourselves to fall victim to a (wholly subjective) narrative about the commodities market at the time, we would never have made the investments in question, and we and our investors would have missed out on the double- and in some cases triple-digit returns that we subsequently enjoyed.
In other words, so long as any company’s underlying operations are sound, and ideally improving, and that company is making money whilst carrying little or no debt, a) it doesn’t matter what the crowd thinks about that company or the sector it’s in and b) it doesn’t matter that its share price is temporarily under pressure. There may even be technical reasons for the share price to be lagging the rest of the market that have absolutely nothing to do with that company’s underlying profitability or revenue growth. It might be, for example, that a large fund just got hit with some heavy redemptions by clients, and is liquidating part of its portfolio, and shares of that company just happen to be among those being sold because they’re more liquid than the fund’s other holdings. The recent history of any company’s share price tells you almost nothing about its underlying health – only about sentiment toward that company in the stock market.
Ben Graham tended to focus on book value as the metric par excellence, but it’s worth noting that book value today is somewhat less relevant than it was in a pre-Internet, less technological age, when so many more businesses were involved in things like extractive industry or manufacturing. In a more services-driven world, book value struggles to give a fair reflection of the underlying worth of a business when the intangible value of so many companies, comprised of things like brand value and intellectual property, is so high.
But there are plenty of other ‘margin of safety’ metrics we can use. Here are a few others that we use in screening for stock selection:
* A minimum 10% cashflow from operations (CFO) yield.
Cashflow from operations is the purest form of cash that a company can generate, because it isn’t “tainted” by cashflow that can come about from either investment or financing – both of which can swing about wildly and be manipulated by management. The CFO yield is calculated by dividing cash from operations by the total value of the company’s debt and equity.
* A price / earnings (p/e) ratio of less than 15 times.
This is a classic Ben Graham metric. This can be calculated by dividing a company’s share price by its earnings per share. Clearly a number of companies will be excluded from any list selected by limiting the target p/e ratio, but who said you needed to own the whole market anyway ? The ‘margin of safety’ investor is more focused, remember, on capital preservation – and owning growth stocks trading on high multiples is also risky, especially when a bull market goes into reverse. The fundamental beauty of a ‘margin of safety’ approach is that any investor who practises it never has to worry too much about the market turning, since he’s primarily defensively positioned in the first place.
* A price / book ratio of less than 1.5x.
And, ideally, less than 1x. Clearly, this can mean that one sometimes has to be patient. And in some cases, some companies may never trade below book value. But the important thing is that a focus on a low price / book ratio means that the cautious investor never wildly overpays for anything.
* A debt / total assets ratio of less than 30%.
One of the killers of any company is being overly indebted. Consider poor old Thomas Cook. Here is what seasoned Japan equity analyst John Seagrim wrote as the company crashed some time ago:
“For twelve years now Thomas Cook has not only been blithely sending holiday makers abroad with absolutely no tangible balance sheet protection at all, but with an ever growing tangible black hole in its fuselage – in the last 12 years that tangible black hole has widened 8 fold from Minus £413ml to Minus £3.3bn! I suppose Thomas Cook’s thinking was, who needs tangible book when all we do is flog European package holidays to those who don’t appear to much like the Europeans, which was sort of fine as long as long as the weather wasn’t – last year Thomas Cook cited a ‘prolonged period of hot weather’ (it’s called ‘summer’) as the reason for their dire 2018 performance.
“One could feel sorry for this (in)famous package holiday pedlar, but all sympathy evaporates when one sees the returns package that accompanied their performance. Despite generating a cumulative 12 year Net Loss of £2.685bn – Thomas Cook generously dished out £366ml in dividends and fished out £300ml in buy backs (but then had to ask for most of it back again with a £400ml rights issue 6 years ago), not to mention CEO Fankhauser’s generous ‘return package’ of £8.3ml over the last five years. The upshot or downshot of this improvidence is that 150,000 stranded Brits now have to be rescued and brought back to BorIsland – an evacuation, the scale of which has not been seen since what was left of the British Expeditionary Force found themselves on the beaches of Dunkirk in May 1940.
“Call me old fashioned but I don’t much care for this capitalism without capital thing, I prefer balance sheets stuffed full of tangible equity not ethereal intangibles like illwill (Thomas Cook has £2.6bn of so called goodwill (in reality ‘illwill’) on its balance sheet, which until this year gave it an illusorily positive book value). So it’s jolly lucky that I do Japan, which is stuffed full of more tangible equity than any other stock market in the world !”
(Never hurts to be reminded of the value on offer in Japan !)
There are three other ‘margin of safety’ attributes that we like to see in our investee companies:
* Cash from operations growth.
We want our companies to be growing. A short-term revenues blip is acceptable in special situations (nobody’s perfect), but we like to ride winners, not losers.
* Return on equity of over 8%, on average, per annum, over the prior five years.
* Share buybacks at appropriate valuations.
Somewhere along the line it became fashionable to become deeply hostile towards share buybacks. Once again, it’s all a question of valuations. If a company’s board decides to buy back its stock at close to, or below, book value, it should be encouraged to do so. Warren Buffett does exactly the same thing at Berkshire Hathaway. Buying back stock when it is historically cheap is a perfectly legitimate deployment of corporate capital. Of course, buying back stock when it is outrageously expensive by any traditional metric is a grotesque abuse of your shareholders.
If we can only get across one aspect of the ‘margin of safety’ approach, it would be to focus on price above absolutely anything else. Not newsflow, not what the so-called experts in the mainstream media think, and not about arbitrary forecasts that may or may not be wildly inaccurate. (Why is nobody ever held to account for issuing ridiculous forecasts that never come close to reality ?) And, at a time when many markets seem egregiously expensive, a focus on ‘margin of safety’ as the cornerstone of your investment approach should pay huge dividends compared to all those investors pursuing a market-relative approach instead.
It’s not our ‘big idea’, of course. In terms of practising our craft and learning about the world we’re merely following in the footsteps of others. Bernoulli himself deserves a name check (as does Peter L. Bernstein). Along with the likes of Benjamin Graham; Adam Smith; Ludwig von Mises; Richard Feynman; Murray Rothbard; Michael Covel; James Montier; Russell Napier; Warren Buffett and the late Charlie Munger. In any event, as Isaac Newton said in 1675:
“If I have seen further it is by standing on the shoulders of giants.”
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:
Get your Free
financial review
…………
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks.
“If you can’t explain it simply, you don’t understand it well enough.”
Get your Free
financial review
There is a great deal of redundancy, me-tooism and superfluity in the provision of fund management. There are too many funds out there versus legitimate investor demand. (‘Many are launched, but few are chosen.’) More fund managers should be asked, ‘What’s your big idea ?’
This is an easy question to ask, but a tough question to answer briefly.
The great value investor, Benjamin Graham, did a pretty good job of answering briefly when he wrote, in the very last chapter of ‘The Intelligent Investor’:
“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto: MARGIN OF SAFETY.”
Those three words contain an entire universe of wisdom.
Safety, of course, means different things to different people. And these days, real safety is a tough thing to come by – it may even be impossible.
Nevertheless, here’s our preferred definition. If we first define risk as the likelihood of incurring a permanent loss of capital – the complete and irreversible destruction of your pension fund, for example – then safety has to be the polar opposite. A ‘safe’ investment, or one approaching the characteristic of safety, is one that offers the least foreseeable likelihood of incurring a permanent loss of capital.
To go one stage further in the cause of total clarity, a ‘safe’ investment is one that also accords the investor a meaningful likelihood of retaining his or her purchasing power over the medium and longer term.
A lot of things flow from these simple concepts.
Before we discovered Benjamin Graham, we stumbled upon Daniel Bernoulli. He popped up within the text of Peter L. Bernstein’s 1998 book ‘Against the Gods’: a history of risk that we would recommend to any investment market ‘completist’. Bernoulli, an 18th Century Dutch mathematician and physicist, once remarked:
“The utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.”
It’s a rather dry-sounding statement, couched in very scientific, if not economist-like, language. But when we came across it in 1998 or 1999, while working for Merrill Lynch, it struck us like a lightning bolt.
Bear in mind that, at the time, the world and his wife were stampeding over themselves in their efforts to make obscene profits in internet stocks. Our almost immediate response to Bernoulli was to conclude that “everyone else” was doing it wrong. What would most matter to our clients, being either affluent, wealthy or very wealthy, would not be how much they might make on an investment – but how much they stood to lose. It was during the first dotcom boom that we also came across the wonderful quote by Lord Overstone:
“No warning can save people determined to grow suddenly rich.”
The only real problem with Benjamin Graham’s ‘margin of safety’ observation – and all that naturally flows from it – is that it’s a ‘get rich slow’ or ‘stay rich’ approach. That may have limited appeal to those seeking a sudden and dramatic uptick in their fortunes. But we think every investor has to pursue an approach that sits easily with their own mental furniture. And we’re happy to take a patient view of things. Patience favours the ‘margin of safety’ investor.
Bernoulli’s observation is probably a little closer to conventional wisdom now. It’s difficult for us to say, because we’ve been living with a focus on absolute return investing for so long now it’s difficult to remember having ever invested any other way. But we maintain that Bernoulli still has a claim – among all his other achievements – to be one of the world’s first behavioural economists. The likes of Kahneman and Tversky have more recently confirmed through extensive research the essential truth of what Bernoulli said three centuries ago: human beings, and especially wealthy human beings, hate losing money far more than they enjoy making it. Hence our focus, ever since discovering Bernoulli, on absolute – as opposed to market-relative – investing. We discuss this issue at greater length in this 23rd August interview with Jeremy McKeown.
So this ‘big idea’ isn’t just good for your portfolio, it’s good for your psychological health, too. Like we say, this is genuinely a ‘big idea’ in every sense, because its implications are far-reaching and profound.
Let’s drill a little deeper into some of the implications of ‘margin of safety’.
One of them is that equity investments, for example, can possess certain ‘safe-ish’ characteristics almost entirely independently of the sector they represent or the type of businesses they are. This is what Warren Buffett described as ‘cigar butt’ investments – shares of businesses that had perhaps one last puff in them but which were being given away for free. If you buy shares of any company when those shares are trading at a meaningful discount to that company’s inherent worth / liquidation value / book value, then you don’t even need to worry about the longer term prospects for that company; if it gets wound up, you still expect to make a profit.
But ‘cigar butt’ (a.k.a. ‘deep value’) investing doesn’t interest us so much, just as Buffett himself moved on from it over the course of his career. Value traps are still traps. Instead, we’re more interested in sustainable businesses with a history of superior shareholder returns and highly competent management – but only when the shares of those businesses happen to be on sale, for whatever reason.
Those last three words – “for whatever reason” – are also important. Because one thing that flows from the ‘margin of safety’ approach, at least from our perspective, is that price is far more important than any other subjective characteristic in an investment. Price is in many respects the only thing that matters. A case in point. When we were buying certain mining and commodity company shares within our fund several years ago, a number of highly respected analysts at a data and news company that shall remain nameless (though it rhymes with ‘Roomberg’) told us that we were mad. “Iron ore ? Oh, that sector’s had it. The commodity boom is over.” If we had allowed ourselves to fall victim to a (wholly subjective) narrative about the commodities market at the time, we would never have made the investments in question, and we and our investors would have missed out on the double- and in some cases triple-digit returns that we subsequently enjoyed.
In other words, so long as any company’s underlying operations are sound, and ideally improving, and that company is making money whilst carrying little or no debt, a) it doesn’t matter what the crowd thinks about that company or the sector it’s in and b) it doesn’t matter that its share price is temporarily under pressure. There may even be technical reasons for the share price to be lagging the rest of the market that have absolutely nothing to do with that company’s underlying profitability or revenue growth. It might be, for example, that a large fund just got hit with some heavy redemptions by clients, and is liquidating part of its portfolio, and shares of that company just happen to be among those being sold because they’re more liquid than the fund’s other holdings. The recent history of any company’s share price tells you almost nothing about its underlying health – only about sentiment toward that company in the stock market.
Ben Graham tended to focus on book value as the metric par excellence, but it’s worth noting that book value today is somewhat less relevant than it was in a pre-Internet, less technological age, when so many more businesses were involved in things like extractive industry or manufacturing. In a more services-driven world, book value struggles to give a fair reflection of the underlying worth of a business when the intangible value of so many companies, comprised of things like brand value and intellectual property, is so high.
But there are plenty of other ‘margin of safety’ metrics we can use. Here are a few others that we use in screening for stock selection:
* A minimum 10% cashflow from operations (CFO) yield.
Cashflow from operations is the purest form of cash that a company can generate, because it isn’t “tainted” by cashflow that can come about from either investment or financing – both of which can swing about wildly and be manipulated by management. The CFO yield is calculated by dividing cash from operations by the total value of the company’s debt and equity.
* A price / earnings (p/e) ratio of less than 15 times.
This is a classic Ben Graham metric. This can be calculated by dividing a company’s share price by its earnings per share. Clearly a number of companies will be excluded from any list selected by limiting the target p/e ratio, but who said you needed to own the whole market anyway ? The ‘margin of safety’ investor is more focused, remember, on capital preservation – and owning growth stocks trading on high multiples is also risky, especially when a bull market goes into reverse. The fundamental beauty of a ‘margin of safety’ approach is that any investor who practises it never has to worry too much about the market turning, since he’s primarily defensively positioned in the first place.
* A price / book ratio of less than 1.5x.
And, ideally, less than 1x. Clearly, this can mean that one sometimes has to be patient. And in some cases, some companies may never trade below book value. But the important thing is that a focus on a low price / book ratio means that the cautious investor never wildly overpays for anything.
* A debt / total assets ratio of less than 30%.
One of the killers of any company is being overly indebted. Consider poor old Thomas Cook. Here is what seasoned Japan equity analyst John Seagrim wrote as the company crashed some time ago:
“For twelve years now Thomas Cook has not only been blithely sending holiday makers abroad with absolutely no tangible balance sheet protection at all, but with an ever growing tangible black hole in its fuselage – in the last 12 years that tangible black hole has widened 8 fold from Minus £413ml to Minus £3.3bn! I suppose Thomas Cook’s thinking was, who needs tangible book when all we do is flog European package holidays to those who don’t appear to much like the Europeans, which was sort of fine as long as long as the weather wasn’t – last year Thomas Cook cited a ‘prolonged period of hot weather’ (it’s called ‘summer’) as the reason for their dire 2018 performance.
“One could feel sorry for this (in)famous package holiday pedlar, but all sympathy evaporates when one sees the returns package that accompanied their performance. Despite generating a cumulative 12 year Net Loss of £2.685bn – Thomas Cook generously dished out £366ml in dividends and fished out £300ml in buy backs (but then had to ask for most of it back again with a £400ml rights issue 6 years ago), not to mention CEO Fankhauser’s generous ‘return package’ of £8.3ml over the last five years. The upshot or downshot of this improvidence is that 150,000 stranded Brits now have to be rescued and brought back to BorIsland – an evacuation, the scale of which has not been seen since what was left of the British Expeditionary Force found themselves on the beaches of Dunkirk in May 1940.
“Call me old fashioned but I don’t much care for this capitalism without capital thing, I prefer balance sheets stuffed full of tangible equity not ethereal intangibles like illwill (Thomas Cook has £2.6bn of so called goodwill (in reality ‘illwill’) on its balance sheet, which until this year gave it an illusorily positive book value). So it’s jolly lucky that I do Japan, which is stuffed full of more tangible equity than any other stock market in the world !”
(Never hurts to be reminded of the value on offer in Japan !)
There are three other ‘margin of safety’ attributes that we like to see in our investee companies:
* Cash from operations growth.
We want our companies to be growing. A short-term revenues blip is acceptable in special situations (nobody’s perfect), but we like to ride winners, not losers.
* Return on equity of over 8%, on average, per annum, over the prior five years.
* Share buybacks at appropriate valuations.
Somewhere along the line it became fashionable to become deeply hostile towards share buybacks. Once again, it’s all a question of valuations. If a company’s board decides to buy back its stock at close to, or below, book value, it should be encouraged to do so. Warren Buffett does exactly the same thing at Berkshire Hathaway. Buying back stock when it is historically cheap is a perfectly legitimate deployment of corporate capital. Of course, buying back stock when it is outrageously expensive by any traditional metric is a grotesque abuse of your shareholders.
If we can only get across one aspect of the ‘margin of safety’ approach, it would be to focus on price above absolutely anything else. Not newsflow, not what the so-called experts in the mainstream media think, and not about arbitrary forecasts that may or may not be wildly inaccurate. (Why is nobody ever held to account for issuing ridiculous forecasts that never come close to reality ?) And, at a time when many markets seem egregiously expensive, a focus on ‘margin of safety’ as the cornerstone of your investment approach should pay huge dividends compared to all those investors pursuing a market-relative approach instead.
It’s not our ‘big idea’, of course. In terms of practising our craft and learning about the world we’re merely following in the footsteps of others. Bernoulli himself deserves a name check (as does Peter L. Bernstein). Along with the likes of Benjamin Graham; Adam Smith; Ludwig von Mises; Richard Feynman; Murray Rothbard; Michael Covel; James Montier; Russell Napier; Warren Buffett and the late Charlie Munger. In any event, as Isaac Newton said in 1675:
“If I have seen further it is by standing on the shoulders of giants.”
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:
Get your Free
financial review
…………
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks.
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