Friday, October 26, 2012

Certainty in investing

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

10 comments:

  1. Amen. PS - Just stop going on Seeking Alpha altogether. You are better than that

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    1. Ha! Great comment, I don't usually go there, but I like to see what's been posted about companies I own, usually nothing, or not much.

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  2. "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."

    Then why do you write up and invest in "Schuff, a potential 10 bagger, or bankrupt?"

    I love your blog, but this doesn't really make sense.

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    1. Preferring something doesn't mean all the time in any circumstance regardless. So yes while I prefer certainty there are times I will invest in something uncertain as well. Schuff is a good example, there is certainty in the value of the assets, which I am buying at a slight discount, and it's a strong company that has weathered many cycles in the past. So the speculation is they will continue to do in the future what they've done in the past.

      The uncertainty with Schuff is the debt. Really any company with debt has that wildcard. I also doubt Schuff will return 10x, maybe 2-3x. They are fascinating.

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  3. Just a thought, but maybe add this to an FAQ? It would be a shame for new people to have this post be buried away in the archives of your site.

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  4. I really enjoyed this post. Great common sense. Thanks.
    Jill

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  5. I agree with most of what you're saying. But one thing you really have to consider is: "Will that cash ever be available to shareholders?"

    If not, then the net-net aspect of the company may be an illusion. Some managements lie around with excess cash for 5 years without distributing/re-purchasing shares with the motivation that they want to create/invest in organic growth.

    And if the business in such a case goes sour, a net-net can go from net-net to overpriced pretty fast.

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  6. In summary, you are saying with certainity we will be able to minimize the degree of loss. the question is why every great investor talks about minimizing the degree of downside and say upside will take care of its own. Why can't we aspire for something like 20-30X ?

    When we buy stocks , we buy partnerships in the bussiness. And I don't know many bussiness which can grow 20-30X in next couple of years. Startups or turnarounds tend to have the potential to grow a singnicant amount. But that begs the question, what percentage of the companies do grow to that size. How many startups are brought to IPO and than make it big. For last decade or two, we can count them on fingertips. But i am sure there are countless startups which failed. So the chances/percentage of hitting the jackpot are minimal. So, it is better to be rational and rational person keeps his expectations low but reasonable and concievable. And if you keep losing money in the hope of hitting the jackpot, either you will be left with nothing to buy anymore or you have to work really hard to get back to starting line. So, be reasonable and acheiving 15-20% on investements is withing reasonable range.

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  7. Sorry to hear about those mails Nate (hope you don't get any more in the future, though I doubt that). On the upside, it's good to see another person whose driving force in investing is not speculation but certainty. It's a rough road we're trudging right now, so going for an overly risky cash move has to give way for a tried-and-true approach.

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