Category Archives: Quotes

Margin of Safety: Secret of Sound Investment

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, in his book, The Intelligent Investor, summed up the secret of sound investment in three words: margin of safety. Warren Buffett, Benjamin Graham’s most famous disciple, explained his mentor’s margin of safety concept this way (Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett): “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

In Chapter 20 (“Margin of Safety” as the Concept of Investment”) of The Intelligent Investor, Benjamin Graham summed up the chapter by saying: “Investment is most intelligent when it is most businesslike”.

“If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success,” said Benjamin Graham. In other words, view a corporate security as an ownership interest in a specific business enterprise.

Benjamin Graham listed four sound business principles and explained how they were related to the securities investor:

(1) “Know what you’re doing – know your business.” Benjamin Graham said that the investor should not try to make “business profits” out of securities – that is, returns in excess of normal interest and dividend income – unless “you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in”.

(2) “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor, it means understanding the conditions under which he will permit someone to decide what is done with his money.

(3) “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” The enterprising investor should make sure that his operations for profit should not be based on optimism but on arithmetic. For every investor who limits his return to a small figure, such as in a conventional bond or preferred stock – he needs to ask for convincing evidence that he is not risking a substantial part of his principal.

(4) “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even others may hesitate or differ.” “In the securities world, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand,” said Benjamin Graham.

Related post: Benjamin Graham’s theory of diversification


A game of Snap, of Old Maid, of Musical Chairs – John Maynard Keynes

keynes
John Maynard Keynes (5 June 1883 – 21 April 1946) – Wikipedia

“For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a  pastime in which he is victor who says Snap neither too soon nor too late, who passed the  Old Maid to his neighbour before the game is over, who secures a chair for himself when  the music stops. These games can be played with zest and enjoyment, though all the
players know that it is the Old Maid which is circulating, or that when the music stops  some of the players will find themselves unseated.”

This quote is from  The General Theory Of Employment, Interest, And Money
– Chapter 12 “The State of Long-term Expectation” (John Maynard Keynes, 1936).

Legendary investor Warren Buffett has also made reference to John Maynard Keynes’ General Theory of Employment, Interest, and Money Chapter 12 (“The State of Long-term Expectation”). In a November 2011 interview with Business Wire CEO Cathy Baron Tamraz, Warren Buffett said: “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.” This advice from Warren Buffett involves two milestone books on investing and economics

John Maynard Keynes made this  “game of Snap, of Old Maid, of Musical Chairs” remark in the context of saying that most professional investors and speculators were “largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the
conventional basis of valuation a short time ahead of the general public.”

Keynes went on to say: “They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’,
but with what the market will value it at, under the influence of mass psychology, three  months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed  propensity. It is an inevitable result of an investment market organised along the lines
described. For it is not sensible to pay 25 for an investment of which you believe the  prospective yield to justify a value of 30, if you also believe that the market will value it  at 20 three months hence.

“Thus the professional investor is forced to concern himself with the anticipation of  impending changes, in the news or in the atmosphere, of the kind by which experience  shows that the mass psychology of the market is most influenced. This is the inevitable
result of investment markets organised with a view to so-called ‘liquidity’. Of the maxims  of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the  doctrine that it is a positive virtue on the part of investment institutions to concentrate
their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing  as liquidity of investment for the community as a whole.”

Keynes then added: “The social object of skilled  investment should be to defeat the dark forces of time and ignorance which envelop our  future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’,  as the Americans so well express it, to outwit the crowd, and to pass the bad, or  depreciating, half-crown to the other fellow.

“This battle of wits to anticipate the basis of conventional valuation a few months hence,  rather than the prospective yield of an investment over a long term of years, does not  even require gulls amongst the public to feed the maws of the professional; — it can be
played by professionals amongst themselves. Nor is it necessary that anyone should keep  his simple faith in the conventional basis of valuation having any genuine long-term  validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a
pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when  the music stops. These games can be played with zest and enjoyment, though all the
players know that it is the Old Maid which is circulating, or that when the music stops  some of the players will find themselves unseated.”

Keynes then put it another way: “Or, to change the metaphor slightly, professional investment may be likened to those
newspaper competitions in which the competitors have to pick out the six prettiest faces  from a hundred photographs, the prize being awarded to the competitor whose choice  most nearly corresponds to the average preferences of the competitors as a whole; so that
each competitor has to pick, not those faces which he himself finds prettiest, but those  which he thinks likeliest to catch the fancy of the other competitors, all of whom are  looking at the problem from the same point of view. It is not a case of choosing those  which, to the best of one’s judgment, are really the prettiest, nor even those which  average opinion genuinely thinks the prettiest. We have reached the third degree where  we devote our intelligences to anticipating what average opinion expects the average
opinion to be. And there are some, I believe, who practise the fourth, fifth and higher  degrees.”

Benjamin Graham’s The Intelligent Investor Chapter 8 (The Investor and Market Fluctuations)

Benjamin Graham’s The Intellingent Investor Chapter 20 (Margin of Safety As The Central Concept Of Investment)

 

 

Warren Buffett on Benjamin Graham’s margin of safety

Benjamin Graham, father of value investing. Source: Wikipedia

“You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing. ” – Warren Buffett on what Benjamin Graham, the father of value investing, meant by having a margin of safety.
Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett


Benjamin Graham’s The Intellingent Investor Chapter 20 (Margin of Safety As The Central Concept Of Investment)

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock   market. Photo: Wikipedia.
Benjamin Graham: “Investment is most intelligent when it is most businesslike.” Photo: Wikipedia.

In a section of his  letter to Berkshire Hathaway shareholders on February 28, 2014 for FY2013, Warren Buffett shared “Some Thoughts About Investing”  (Post: Investment is most intelligent when it is most businesslike) .

He also shared more about Benjamin Graham, his teacher and friend, and about Benjamin Graham’s book, The Intelligent Investor .

“Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today.”

So what is   Chapter 20  in the later editions of The Intelligent Investor all about?

As Chapter 20’s title, “Margin of Safety” as the Central Concept of Investment, suggests,  “margin of safety” is the motto governing  Benjamin Graham’s investment policy. It is the thread that runs through all the investment policy discussion in preceding chapters.

The chapter started off with the margin-of-safety concept as applied to “fixed value investments”.

“All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed asset charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.)

The margin-of-safety concept as applied to “fixed value investments” can be carried over to the field of common stocks, says Chapter 20, but with some necessary modifications.

“There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depressed conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power. That was the position of a host of strongly financed industrial companies at the low price levels of 1932-33. In such instances, the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else – but this is a small drawback as compared with his advantages.”

Elsewhere in Chapter 20, it says “the risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities”. “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.”

As for growth stocks, the danger lies in the market’s “tendency to set prices that will not be adequately protected by a conservative projection of future earnings”.

The margin of safety is much more evident in the field of undervalued  or bargain securities.  By definition, it means there is a favorable difference between price on the one hand and indicated or appraised value on the other. “That difference is the margin of safety”.

The gem of Chapter 20 comes in this famous Benjamin Graham quote: “Investment is most intelligent when it is most businesslike.”

“It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they gained success in their own undertakings.”

Related posts: (1) The Intelligent Investor Chapter 8

(2) Warren Buffett on intelligent investing

Recommended reading:

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)

 

When Warren Buffett and Charlie Munger buy stocks…

In his letter (dated February 28, 2014 for FY2013) to Berkshire Hathaway shareholders, Warren Buffett shared some thoughts about investing in one  section. In a sub-section, he gave pointers on the analysis involved in buying stocks.

Warren Buffett said: “When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects.

“In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions. It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

“Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power. I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497,  paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. That’s the “what” of investing for the non-professional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.

“Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better longterm results than the knowledgeable professional who is blind to even a single weakness. If “investors” frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

“Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm. My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P
500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013

Warren Buffett’s investment tales

In his letter to Berkshire Hathaway shareholders on February 28, 2014 for FY2013, Warren Buffett, among other things, shared “Some Thoughts About Investing”.

To illustrate certain fundamentals of investing, Warren Buffett told two tales in the letter. The two tales are about two small non-stock investments that Warren Buffett made long ago.

“Though neither changed my net worth by much, they are instructive,” said Warren Buffett.

First tale

The first tale began in Nebraska. “From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath than in our recent Great Recession. In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
“I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.”

Second tale

Warren Buffett then went on to tell the second tale.

“In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to NYU that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
“Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.
“I joined a small group, including Larry and my friend Fred Rose, that purchased the parcel. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our original equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
“Income from both the farm and the NYU real estate will probably increase in the decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.
“I tell these tales to illustrate certain fundamentals of investing: You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”  Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.  If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
“With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
“Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”).

“My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

“There is one major difference between my two small investments and an investment in stocks. Stocks
provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm
or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is.

“After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
“Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
“Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

Climate of fear is your friend

“A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy. During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?”

This quote from Warren Buffett is a gem: “Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013