The joy of higher return with no more risk

Risk/reward

The holy grail of investing

An investor buys a stock at a fair price. Another investor buys the same stock at a bargain price one month later. The riskiness of the company is identical for both purchasers. The bargain hunter will have obtained several advantages: they will obtain a higher return and they will have obtained a Margin of Safety. The Margin of Safety is useful because estimating the fair value of a stock is inherently tricky. In buying the stock at a lower price the bargain hunter has also reduced his risk.

Some adherents to the ‘stock market is essentially efficient’ school of thought will declare the previous paragraph to be a load of hooey. To answer the critics we can flesh the idea out a bit.

Risk/reward is not a simple trade-off. Last week my post contained a discussion of the risk/reward idea. My conclusion was that the expression risk/reward is too simplistic and is misunderstood. Investors are better off using probabilistic thinking. It’s a matter of assessing, in a sensible manner, the best expected return having regard to the chances of gain, the amount of potential gain less the chances of loss and the amount of potential loss. See here.

Risk when market down

A representative of a savings-and-loan company came to Benjamin Graham with several questions. “The first question he asked me was “Don’t you think that common stocks now are less safe than before because of the decline in the market?” That hit me between the eyes. Here were financial people who could seriously consider that stocks less safe because they have declined in price than they were after they had advanced in price.” (Graham, The Intelligent Investor, 1973, p.10)

The point very simply is that stocks in general and any given stock are no more risky when priced as bargains, and probably less risky. I ask the reader to ponder whether, with all the benefit of hindsight, stocks were more or less risky in January 2009 at the depths of the Financial Crisis bear market? The answer is that they were less risky. The same can probably (probabilistic thinking) be said of May 2020. Some fine companies seem to be trading at bargain prices.

It has been argued that seeking better returns by buying value is associated with higher risk because higher value appears in risky economic times. Such simplistic thinking ignores the insights of Benjamin Graham, Warren Buffett, John Templeton and Philip Fisher about buying with a Margin of Safety and buying at a ‘time of maximum pessimism’. These investing greats are correct because they have demonstrated that their approach works in the real world.

And blessedly, bargains appear in the stock market all the time, not just in risky economic times. Which incidentally, is why investing in individual stocks rather than index funds or ETFs is superior.

Howard Marks is Chairman and Cofounder of Oaktree Capital Management, a Los Angeles-based investment firm. He has a finance degree from Wharton and an MBA from the University of Chicago. He is the author of The most important thing illuminated – Uncommon Sense for Thoughtful Investors published in 2013. (Marks, 2013) He has a wonderful expression, perversity of risk, to describe risks going down in down markets and up in up markets. He writes: “Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” (Marks, 2013)p.68. (emphasis added)

I know many investors firmly believe the market is fairly efficient. As evidence they cite the fact that it is hard to beat the market. I personally believe the stock market is messy and quite inefficient. I explain my thoughts in a post here.

Margin of Safety

Chapter 20 in The Intelligent Investor by Benjamin Graham is titled ‘“Margin of Safety” as the Central Concept of Investment’. Benjamin Graham put it this way: “In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secrets of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.” (Graham, The Intelligent Investor 1973)p.277.

Warren Buffett, after referring to the difficulties everyone has in valuing companies says: “At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we understand. That means they must be relatively simple and stable in character….Second, and equally import, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin of safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.” (emphasis added)

It is interesting to note that Warren Buffett has been forced to compromise this cornerstone principle somewhat because of the size of Berkshire Hathaway. As noted earlier he has written: “we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett/Cunningham, 1998, p.85) The individual investor is not burdened by this problem. There should be no compromise on the ‘very attractive price’.

How is it possible?

The burning question is how superb companies can end up trading at a price that is temporarily depressed. Almost by definition a stock selling at a bargain price is highly unpopular.

Here is a list, in no particular order, of some of the reasons stocks may sell at bargain prices. These may occur by themselves or in combination. The following is not meant to be exhaustive.

They are little known

The street does not like multiple voting shares

The company is not well understood

There is a general lack of interest in the sector or industry

Trading in the company shares is too illiquid for institutional investors

Something controversial has happened

Something scary has happened

A product is found to be dangerous or unhealthy

The business is thought a bit unsavory e.g. the death business

Management is investing in the business for the long term and sacrificing short term profits

In other respects the timing of the payoff of the investment is uncertain

There has been recent weak earnings or sales

Management is guiding for lower future sales and/or profits

There is poor visibility of future sales and earnings increases

Management is planning a large acquisition

There is uncertainty regarding succession planning

There is something unconventional about the company

Funds that hold the stocks are forced to sell as a result of panicky withdrawals

Funds are forced to sell for regulatory reasons

Investors are forced to sell because of margin calls

Investors are selling in a panic in a crisis or bursting bubble

Of course, the negatives may be well taken, in the sense they show the company is not superb and the company should be avoided. On the other hand, investors may be unduly worried or simply short sighted and therein lies opportunity

Conclusion

It is of real and practical importance to investors that you can earn a better return without taking additional risk. You do this by investing with an edge. In the Motherlode the edge is a combination of buying superb companies with a Margin of Safety using sound principles of operation and applying the insights we learn from behavioral psychology. This is not easy but, it is doable.

To learn more about Margin of Safety take a look at Chapter 26. Buying with a margin of safety

To understand what I mean regarding ‘sound principles of operation’ you can look at Part 4: Principles of Operation

As for the insights we can learn from behavioral psychology, please see Part 2: Human Foibles and Investment Decision Making

For readers wanting to dig deeper into the subject of risk take a look at Chapter 4. Risk and Uncertainty

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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