Investment style
Fuzzy thinking
In this post I propose to take issue with a very high-profile money manager who has been in the business for 42 years. His name is Bill Nygren.
He was quote recently as saying: “Buying great businesses at average prices is as much value investing as buying average businesses at great prices. The idea that every business trading at a low P/E, P/B, P/anything ratio is a “value stock” is just plain stupid. Some businesses are truly inferior and deserve to sell at low multiples. GARP is a segment of value investing.” (Emphasis added)
I disagree with two things in that quote. First, he seems to be saying that investors should be looking to buy great businesses at “average prices”. Second, he describes GARP as a segment of “value investing.” I should add that what he says about low multiples I completely agree with.
Bill Nygren is a partner and the chief investment officer-U.S. at Harris Associates/Oakmark Funds. He is also the co-portfolio manager of two Oakmark Funds.
Warren Buffett
Let’s compare what Nygren says with what Warren Buffett says about his approach to investing: “Our equity-investing strategy remains little changed from what it was…when we said in the 1977 annual report: ‘We select our marketable equity securities in much the way we would evaluate a business for acquisition it its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and, (d) available at a very attractive price.’ We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America.1998,) p85 (Emphasis added)
He continues: “But how, you will ask, does one decide what’s ‘attractive’? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘’value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.”
“We view that as fuzzy thinking (in which, it must me confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, 1998) p85
So what Buffett is saying is that an investor who is not constrained by having to buy and sell stocks in a massive portfolio that may be hundreds of millions of dollars in size or even billions of dollars in size, can stick with buying only great companies and then only at very attractive prices. That is fundamentally different than buying those companies at average or reasonable prices.
Benjamin Graham
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, fourth revised edition. 1973) p277 (Emphasis added)
In a word, Margin of Safety is buying a stock at a significant discount to one’s best estimate of fair value. We do this because estimates of fair value are a stab in the dark, not a precise calculation. Also, if you can buy when a stock is on sale, your return will be enhanced. But, how on earth is this done?
Timing by way of price
There is a threshold issue. We need to think about whether buying with a margin of safety is really the closet practice of market timing.
Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure-fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.
Benjamin Graham makes a distinction between ‘the way of timing’ and ‘the way of pricing’. He writes:
“Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (Graham, 1973) p95 (Emphasis added)
This quote makes clear that the way of pricing is not the practice of market timing. Graham goes on to develop his thesis of the way of pricing and ultimately calls it buying with a margin of safety.
Conclusion
For my money, I do not want to buy great businesses at average prices. Nor do I want to buy average businesses at great prices. I want to stick to great businesses at very attractive prices.
What Graham and Buffett are both saying is that one should only be buying a stock when it is on sale at a bargain price. Paying a reasonable price won’t cut it. Growth at a reasonable price or an average price sounds reasonable but it is fuzzy thinking and wrong.
+++++++++++++++
You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
+++++++++++++++
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
+++++++++++++++
You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
+++++++++++++++
There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
If you like this blog, tell your friends about it
And don’t hesitate to provide comments or share on Twitter and Facebook