I will occasionally get an email from a reader saying they love my blog, then proceed to tell me about some great stock that's selling at 2x book, that's a "good earner", and has great potential. I sometimes wonder how much these people have actually read what I write about. I haven't received any emails like that recently, but I've been thinking about the role certainty plays in investment decisions.
I prefer certainty over uncertainty when making analyzing an investment. It's such a simple thing to say, I doubt any readers would disagree, but the investment style exhibited by most market participants disagrees with this statement. When more certainty exists assumptions are minimized and minimizing assumptions leads to less errors. I believe this is the reason I enjoy investing in net-nets, and companies on an asset basis. On a balance sheet, cash is cash, no assumptions are presumed, the book value of cash and market value of cash are one in the same. At the opposite end of the spectrum future earnings are at best a guess, maybe they fit a trend, but the truth is no one knows the future and what it holds. For everyone projecting earnings five and ten years out I want to see your earnings models from 2006, and 2007, were they accurate?
For an asset based investment uncertainty starts to creep in the further we move down the balance sheet. This is why when looking at net-net's Graham added a discount factor for receivables, and inventory, and finally property plant and equipment. The uncertainty is the highest with fixed assets, so the discount is the greatest.
The same is true with earnings, there is little uncertainty (usually) with revenue, but by the time we get to earnings all sorts of assumptions are incorporated adding an uncertain factor. This is also a reason that cash flow is preferable to earnings, cash is more certain and less prone to manipulation.
When I profile a cashbox, I get a lot of negative comments. A cash box is a company where the cash is a significant component of the market cap, and in some cases exceeds it. Usually the value of the actual business is small. Most of the comments I receive discuss how terrible the business is, and question why I'd want to invest in something so bad. I view it differently, a cash box minimizes uncertainty. When I buy a cash box I know for certain what I'm buying, maybe it's a $1 for $.75, or even $1 for $.50. The only uncertain thing is what the business might do, but my investment is protected against failure, because I purchased the certain thing cheap.
If I could buy a good company selling at a cheap price with the same amount of certainty as a cash box I would prefer the better company. The problem is these situations don't exist. There are no blue chip companies selling for NCAV, or a deeply discounted book value. Even the cheapest blue chips have a high uncertainty factor. Will earnings continue to be stable? What if margins shrink? What if demand for the product drops? What if the internet changes the business model? I do own some large caps, two actually, with high degrees of certainty. Both of my large cap holdings have virtual monopolies, or duopolies in their respective market, the certainty level is high.
There is a trade-off though, a company with certainty's returns are usually limited. A cashbox is never going to return 400%. A net-net isn't going to become the next Apple, at most they might return 50-100%. Occasionally a cheap certain stock will triple or quadruple, and very rarely more. The opposite is true for uncertain stocks, Apple fell to the $70s when it was announced Steve Jobs had cancer. That was the ultimate uncertainty, the market felt the company's future was cloudy, uncertainty was at a high, and the stock sold cheap. Uncertainty lifted and the stock has almost gone up 10x since then.
I believe Graham tried to encapsulate this idea in his discussion of investment return, and speculative return. An investment return is a certain thing, whereas a speculative return isn't certain, but it could be substantial.
I believe certainty is inversely correlated with a margin of safety. If a cash box is liquidating dollars for $.95 I don't need a margin of safety, my return, and the value of the assets are almost guaranteed. If I need to predict what car sales will look like in five years for an investment to work, I need to buy at a bigger discount to incorporate the chance that my prediction is wrong.
Sometimes investors fool themselves with the margin of safety concept. I will read writeups on Seeking Alpha that go something like this: earnings will grow from $.95 to $3.25 in 10 years, and discounted back at 15% (to be conservative) means the stock is worth $85, but it's only selling or $65, so I have a strong margin of safety. Note to all math nerds, I have no clue if the numbers work, I just made them, and the discount rate up.
When I read something like that I don't see anything safe, unless the company has a contract for ten years of earnings, growth is a gamble. And just because the current price is sitting below something a formula spit out doesn't make it "safe" even if there's a large discrepancy. I don't mind buying companies for their earning power, but I like to do it in what I consider a more certain way. As an example, a company has consistently earned $3-5 per share for years, even in down markets, and is selling for $15, would be considered "safe" to me. It would be even safer if book value was $13 per share, something close to the current price.
In summary, I want to look for investments where assumptions I need to make are minimized, and my downside is certain. I much prefer an investment where the absolute maximum loss is small to non-existant verses one where I have the potential to make 30x my money, or lose it all. I'm not a 20 punch Warren Buffett investor, but I have found it's worthwhile to be patient and wait for the right types of investments. And to anyone who thinks cheap companies aren't out there right now, there are over 60,000 public companies worldwide, some proportion of those are certain, and cheap. In Japan alone there are over 300 companies selling for less than cash. It always pays to be patient!
Talk to Nate
Disclosure: No positions mentioned