Timing &
Pricing in Equity Investing
Investor’s Query: This is regarding my direct
equity investment monthly purchase - where five stocks are purchased each
month. While I understand diversification over time, I feel when we buy the
stocks we have to seek an opportunity to buy at value as well. By that, I mean
seek to buy the selected stocks close to it monthly low or 6 monthly low. For
example, if you are this month's purchase done, here is what I see:
1.
Bharat
forge - monthly low was at Rs. 289/-, bought at Rs. 310/-
2.
Aditya
Birla - monthly low was at Rs. 764/-, bought at Rs. 811/-
3.
Bharati
Airtel - monthly low was at Rs. 280/- bought at Rs. 321/-
4.
LNT -
monthly low was at Rs. 1,332/- bought at Rs. 1,441/-
5.
Nestle -
monthly low was at Rs. 4,405/- bought at Rs. 4,524/-
We bought
Bharthi Airtel at 10% above its monthly low, Bharat forge 8% above its monthly
low, L&T was bought 8% above its monthly low and so on. This will impact my
direct equity portfolio performance.
Please
let me know if we can fix this from next month onwards? Alternatively, we can
look at the stocks to be purchased, look for a value ranges then go and
purchase.
Mr. Gerard Colaco: The Booth School of Business
at the University of Chicago is one of the finest institutions in the world for
higher education in finance and investment. Students who enrol for its
post-graduate or doctoral courses generally do not fail to see a sign placed at
its entrance with the intriguing acronym “TINSTAAFL”. The acronym stands for
'There is no such thing as a free lunch,' or as a true American would call it,
"There ain't no such thing as a free lunch."
In the context of the education sought to be imparted at the Chicago Booth School of Business, this saying simply means that from time to time, various participants in the securities market will hit upon what they believe is a brilliant new way to master the markets and purchase securities based on certain parameters which they believe will give them superior returns.
Many of these parameters can easily be proved to have worked in the past. This is not at all surprising, because investment is a field where we are always wise by hindsight. Unfortunately however, the advantages that these strategies are supposed to cough up, have a nasty habit of evaporating when tried in the present, for the future, with the actual commitment of money thereto. Trying to obtain value in individual stocks is one such stratagem that promises much, but delivers nothing, and has a high probability of taking away from the benefits of a disciplined investment programme based on logic and common sense.
Continuing with my example of the Booth School of Business, the professors there will at some point of time tell their students that the only thing that comes close to a free lunch in investment is diversification. Warren Buffett had his finger on the button when he declared that “Risk comes from not knowing what you are doing.” And Buffett himself prescribed the antidote to his definition of risk, when he stated that “Diversification is a protection against ignorance.”
Charlie Munger, director of Berkshire Hathaway and long-time partner of Warren Buffett, probably has the answer to the query of client below. He states: “It’s in the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the markets, which is a seriously dumb thing to do. Conservative investing with steady savings, without expecting miracles, is the way to go.”
So I would not try to time the markets. I would also not try to time individual stocks. But I would definitely try to be aware of and recognise when there is a value in the market as a whole. For this, I would rely not on the highs and lows of individual stocks, but the concept of the 'margin of safety' that Benjamin Graham gave us.
Translating the margin of safety into a simple thumb rule, I would be more aggressive in my investment programme (that is I would invest more if funds were available) when the popular indices were at least 25% below their previous peak. But even here, I would not stray from the path of diversification and would not favour stock whose values were at 'lows'.
It is undoubtedly true that Graham himself applied the margin of safety successfully to individual stocks for an impressive period of time. But as world stock markets grew, evolved and became more efficient, Graham himself admitted that individual stock analysis would no longer be worth it. In an interview to Charles D Ellis shortly before his death in 1976, Graham was asked:
"In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?”
Graham answered: “In general, no. I am no longer an advocate of elaborate techniques in order to find superior value opportunities. This was a rewarding activity, say 40 years ago, when 'Graham and Dodd' was first published. But the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies. But in the light of the enormous amount of research now being carried out, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I am on the side of the efficient market school of thought now generally accepted by the professors."
I conclude with two quotes which I use with boring repetitiveness. The first is from John Bogle and I am amazed at how investors never fail to grasp and be guided by its timeless wisdom: “Stay the course. No matter what happens, stick to your investment program. I’ve said 'Stay the course' a thousand times and I meant it every time. It is the most important single piece of investment wisdom I can give you.”
Whenever I come across yet another investor brainwave, I remember two things. One is a definition of the word "Euphoria". Some wag defined 'euphoria' as the feeling one gets from the time he stumbles upon the world's greatest idea, to the time he discovers what's wrong with it! The other is a saying from Warren Buffett: “Lethargy bordering on sloth remains the cornerstone of our investment policy.”
When clients or other investment 'advisers' want to go against the greats, I never discourage them from doing so, or argue with them. I only tell them not to run their ideas past me, and not to get back to me when things they did on their own blow up in their faces. I will stick to diversification with dogged determination, whether in my own investments or for my clients.
In the context of the education sought to be imparted at the Chicago Booth School of Business, this saying simply means that from time to time, various participants in the securities market will hit upon what they believe is a brilliant new way to master the markets and purchase securities based on certain parameters which they believe will give them superior returns.
Many of these parameters can easily be proved to have worked in the past. This is not at all surprising, because investment is a field where we are always wise by hindsight. Unfortunately however, the advantages that these strategies are supposed to cough up, have a nasty habit of evaporating when tried in the present, for the future, with the actual commitment of money thereto. Trying to obtain value in individual stocks is one such stratagem that promises much, but delivers nothing, and has a high probability of taking away from the benefits of a disciplined investment programme based on logic and common sense.
Continuing with my example of the Booth School of Business, the professors there will at some point of time tell their students that the only thing that comes close to a free lunch in investment is diversification. Warren Buffett had his finger on the button when he declared that “Risk comes from not knowing what you are doing.” And Buffett himself prescribed the antidote to his definition of risk, when he stated that “Diversification is a protection against ignorance.”
Charlie Munger, director of Berkshire Hathaway and long-time partner of Warren Buffett, probably has the answer to the query of client below. He states: “It’s in the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the markets, which is a seriously dumb thing to do. Conservative investing with steady savings, without expecting miracles, is the way to go.”
So I would not try to time the markets. I would also not try to time individual stocks. But I would definitely try to be aware of and recognise when there is a value in the market as a whole. For this, I would rely not on the highs and lows of individual stocks, but the concept of the 'margin of safety' that Benjamin Graham gave us.
Translating the margin of safety into a simple thumb rule, I would be more aggressive in my investment programme (that is I would invest more if funds were available) when the popular indices were at least 25% below their previous peak. But even here, I would not stray from the path of diversification and would not favour stock whose values were at 'lows'.
It is undoubtedly true that Graham himself applied the margin of safety successfully to individual stocks for an impressive period of time. But as world stock markets grew, evolved and became more efficient, Graham himself admitted that individual stock analysis would no longer be worth it. In an interview to Charles D Ellis shortly before his death in 1976, Graham was asked:
"In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?”
Graham answered: “In general, no. I am no longer an advocate of elaborate techniques in order to find superior value opportunities. This was a rewarding activity, say 40 years ago, when 'Graham and Dodd' was first published. But the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies. But in the light of the enormous amount of research now being carried out, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I am on the side of the efficient market school of thought now generally accepted by the professors."
I conclude with two quotes which I use with boring repetitiveness. The first is from John Bogle and I am amazed at how investors never fail to grasp and be guided by its timeless wisdom: “Stay the course. No matter what happens, stick to your investment program. I’ve said 'Stay the course' a thousand times and I meant it every time. It is the most important single piece of investment wisdom I can give you.”
Whenever I come across yet another investor brainwave, I remember two things. One is a definition of the word "Euphoria". Some wag defined 'euphoria' as the feeling one gets from the time he stumbles upon the world's greatest idea, to the time he discovers what's wrong with it! The other is a saying from Warren Buffett: “Lethargy bordering on sloth remains the cornerstone of our investment policy.”
When clients or other investment 'advisers' want to go against the greats, I never discourage them from doing so, or argue with them. I only tell them not to run their ideas past me, and not to get back to me when things they did on their own blow up in their faces. I will stick to diversification with dogged determination, whether in my own investments or for my clients.
Mr. Harish Rao: Agree with Gerard's wonderful
words of wisdom. And I may add Harry Markowitz's words "Diversification is the only
free lunch". Not bad, coming from the father of MPT and a recipient of the
Nobel Prize in Economics.
Also, it may be prudent to highlight what Roger Gibson in his masterly
book on Asset Allocation remarked as the best Investment Worldview for an
advisor and investor - that Market Timing and Security selection is not
possible even in a remotely consistent manner during portfolio construction.
William Bernstein added that if it indeed turned out to be right, then it was
possibly because of luck and not skill.
Here the client has combined two of the worst behavioural finance biases
- Hindsight and Overconfidence. Hindsight has provided him a pattern and
investment theory, and now he is confident that something can be done from the
next month. This is dangerous. Really dangerous.
Investor’s query: When we buy individual stocks, I would like to paraphrase Warren Buffet:
Investor’s query: When we buy individual stocks, I would like to paraphrase Warren Buffet:
"We
want the business to be one (a) that we can understand; (b) with favourable
long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”
"What
is 'investing' if it is not the act of seeking value at least sufficient to
justify the amount paid?”
In Financial
Plan, you have recommended 67 me stocks suggests sufficient diligence has been
done by you towards criteria a), b) and c) listed above. I am comfortable with
that. However I believed you would also identify attractive price ranges for
the stocks before we buy each month. I believe item d) is as important as the
other three criteria. I am not comfortable with the approach of buying a stock
at any price randomly.
To quote
Warren Buffet: “… 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."
Mr. Gerard Colaco: I think there is confusion here on the part of Mr. ABC between lump sum investments and systematic investments, and between picking and choosing individual stocks and the construction of a portfolio. Let me try to clear the air.
First of all, we must understand our limitations, whether as investors or advisers, when calculating the margin of safety of an individual stock. Warren Buffett can undoubtedly do this. A very few other great value investors could also do this. The rest of us cannot. Otherwise, all of us would be Warren Buffett!
Therefore, I try to deal with what every normal, individual investor can do, with a little bit of self-discipline and common sense. We are under the mistaken impression that Warren Buffet is an investor. This is wrong. He is primarily a businessman. Despite using the margin of safety, he has made horrible mistakes. His investments in the past in equity shares of The Washington Post and Salomon Brothers are classic examples of poor choices, despite using the margin of safety.
However, Warrant Buffet had the wherewithal to then buy controlling stakes of these companies, get on the boards of directors of the companies or place his nominees there, and attempt to swing the companies around. Can a normal investor do this? Don't get me wrong. I am not disagreeing with Warren Buffett. But I have found that most investors do not analyse his statements or take them in the correct context.
Warren Buffett's pronouncements on tax are totally different from his pronouncements on business or ethics and again different from his statements on investment. Where investment is concerned, there is a further distinction between Buffett talking about institutional investment and individual investment. What applies to investors like Mr. ABC is Buffett's advice to the common investor.
Here, Warren Buffett’s advice is simple, brief and very correct. And that advice has consistently been (refer to the 1996 and 2003 annual reports of Berkshire Hathaway) to make regular investments in low-cost, no-load broad index funds. No stock picking, no margin of safety, just recurring investment in the market as a whole, keeping costs low.
Now let us examine the 'margin of safety' itself. The first point to understand is that the 'margin of safety' is not Warren Buffett’s concept. It is Benjamin Graham’s. Graham had clear rules for applying the concept of the margin of safety to stock picking. Graham was successful at this, as were very few of his students including Warren Buffett, but not the vast majority of common investors. That is why Benjamin Graham himself reduced the margin of safety to a thumb rule, which is: “Ensure that you do not pay too high a price for stocks.”
I now come to the most important point of all. Benjamin Graham’s margin of safety, by his own admission, is applicable only to lump sum, investments and not to systematic investments. I quote from “The Intelligent Investor” where Graham states as follows: “Dollar-cost averaging means simply that the practitioner invests in common stocks, the same number of dollars each month or each quarter. In this way, he buys more shares when the market is low than when it is high and he is likely to end up with a satisfactory overall price for all his holdings.”
When you look at Benjamin Graham’s own opinion about systematic investment (called ‘dollar-cost averaging’ in the US), you see that the very nature of systematic investment ensures a satisfactory price to the investor in the long-run. Adherence to the systematic investment program is the important thing here because the program itself is designed to take care of the margin of safety.
The next area in which Mr. ABC is making a mistake is focusing on stocks and not on the portfolio. Stocks are absolutely unimportant beyond basic selection of a diversified basket of the main economic segments, the major sectors therein and the important stocks in each sector. Thereafter the focus must be only on watching overall portfolio returns.
This is why some of the most successful investments in the US are low-cost no-load total stock market index funds. They buy and hold every stock traded in the stock markets of that country, without bothering to see whether an individual stock is overpriced, underpriced or correctly priced. The final word here must come from Dr William Bernstein who states: “Appreciate that diversified portfolios behave very differently than the individual assets in them, in much the same way that a cake tastes different from shortening, flour, butter and sugar. This is called portfolio theory and is critical to your future success.”
To summarise, I stand by my advice. It is essential to calculate the margin of safety when I am making lump sum investment. I believe that when the popular indices are 25 percent below their last peak in the Indian context, there is an adequate margin of safety to start committing lump sums to the stock market.
I know that I cannot calculate the margin of safety on individual stocks. But common sense tells me that I can form a fair opinion of the margin of safety in the stock market as a whole. I understand that Mr. ABC’s investments are not lump sum investments but systematic investments. Here, adherence to the investment program, diversification, the reinvestment of dividends and a focus on portfolio risk and return are important not opinions about, or calculations of the prices of individual stocks.
Mr. Gerard Colaco: I think there is confusion here on the part of Mr. ABC between lump sum investments and systematic investments, and between picking and choosing individual stocks and the construction of a portfolio. Let me try to clear the air.
First of all, we must understand our limitations, whether as investors or advisers, when calculating the margin of safety of an individual stock. Warren Buffett can undoubtedly do this. A very few other great value investors could also do this. The rest of us cannot. Otherwise, all of us would be Warren Buffett!
Therefore, I try to deal with what every normal, individual investor can do, with a little bit of self-discipline and common sense. We are under the mistaken impression that Warren Buffet is an investor. This is wrong. He is primarily a businessman. Despite using the margin of safety, he has made horrible mistakes. His investments in the past in equity shares of The Washington Post and Salomon Brothers are classic examples of poor choices, despite using the margin of safety.
However, Warrant Buffet had the wherewithal to then buy controlling stakes of these companies, get on the boards of directors of the companies or place his nominees there, and attempt to swing the companies around. Can a normal investor do this? Don't get me wrong. I am not disagreeing with Warren Buffett. But I have found that most investors do not analyse his statements or take them in the correct context.
Warren Buffett's pronouncements on tax are totally different from his pronouncements on business or ethics and again different from his statements on investment. Where investment is concerned, there is a further distinction between Buffett talking about institutional investment and individual investment. What applies to investors like Mr. ABC is Buffett's advice to the common investor.
Here, Warren Buffett’s advice is simple, brief and very correct. And that advice has consistently been (refer to the 1996 and 2003 annual reports of Berkshire Hathaway) to make regular investments in low-cost, no-load broad index funds. No stock picking, no margin of safety, just recurring investment in the market as a whole, keeping costs low.
Now let us examine the 'margin of safety' itself. The first point to understand is that the 'margin of safety' is not Warren Buffett’s concept. It is Benjamin Graham’s. Graham had clear rules for applying the concept of the margin of safety to stock picking. Graham was successful at this, as were very few of his students including Warren Buffett, but not the vast majority of common investors. That is why Benjamin Graham himself reduced the margin of safety to a thumb rule, which is: “Ensure that you do not pay too high a price for stocks.”
I now come to the most important point of all. Benjamin Graham’s margin of safety, by his own admission, is applicable only to lump sum, investments and not to systematic investments. I quote from “The Intelligent Investor” where Graham states as follows: “Dollar-cost averaging means simply that the practitioner invests in common stocks, the same number of dollars each month or each quarter. In this way, he buys more shares when the market is low than when it is high and he is likely to end up with a satisfactory overall price for all his holdings.”
When you look at Benjamin Graham’s own opinion about systematic investment (called ‘dollar-cost averaging’ in the US), you see that the very nature of systematic investment ensures a satisfactory price to the investor in the long-run. Adherence to the systematic investment program is the important thing here because the program itself is designed to take care of the margin of safety.
The next area in which Mr. ABC is making a mistake is focusing on stocks and not on the portfolio. Stocks are absolutely unimportant beyond basic selection of a diversified basket of the main economic segments, the major sectors therein and the important stocks in each sector. Thereafter the focus must be only on watching overall portfolio returns.
This is why some of the most successful investments in the US are low-cost no-load total stock market index funds. They buy and hold every stock traded in the stock markets of that country, without bothering to see whether an individual stock is overpriced, underpriced or correctly priced. The final word here must come from Dr William Bernstein who states: “Appreciate that diversified portfolios behave very differently than the individual assets in them, in much the same way that a cake tastes different from shortening, flour, butter and sugar. This is called portfolio theory and is critical to your future success.”
To summarise, I stand by my advice. It is essential to calculate the margin of safety when I am making lump sum investment. I believe that when the popular indices are 25 percent below their last peak in the Indian context, there is an adequate margin of safety to start committing lump sums to the stock market.
I know that I cannot calculate the margin of safety on individual stocks. But common sense tells me that I can form a fair opinion of the margin of safety in the stock market as a whole. I understand that Mr. ABC’s investments are not lump sum investments but systematic investments. Here, adherence to the investment program, diversification, the reinvestment of dividends and a focus on portfolio risk and return are important not opinions about, or calculations of the prices of individual stocks.
Mr. Harish Rao: The investor extensively quotes
Warren Buffett. I think it is time to tell him, 'We are NOT Warren Buffett'.
And even Buffett did not mean, ‘Buying at an attractive price = Buying at the
lowest price’. Buying at the lowest and selling at the highest cannot be done
by anyone, except liars.
Also, Buffett does not practice and
advocate diversification amongst professional investors and fund managers. His
credo is put all your eggs in one basket, but watch it carefully. He however
recommends Diversification for the Retail investor.
It is important to give this
perspective to the client.
