Basic Investing Philosophy II
OK, so if investing in companies whose stock trades cheaply relative to its earnings or companies whose stock trades at or below book value has historically provided a return greater than that of the stock market as a whole, which of these two strategies should I choose and how should I go about actually implementing it?
I’m not a fan of the low P/E approach as I simply have a hard time finding a way to effectively implement it. The phrase ‘low P/E’ connotes relativity. So you have to rank your universe of potential investments. That means calculating P/E for a universe of stocks. My immediate problem is the denominator; which earnings? Last year’s? the latest 12 months’? the current year’s forecast earnings? or Graham’s 10 year average earnings? I have difficulty with all of these. Last year’s earnings could be an aberration, so out-of-the-norm that they are almost meaningless. Those of the last 12 months’, likewise. The current year’s? That’s a forecast, a big NO-NO in my book. Just look at the accuracy of the Wall Street analyst community. Dismal! And why do I think I could do any better? Lastly, the Graham 10 year average seems to have some intellectual legs, but, by golly, I’m not doing all that work (unless, of course, you can assure me that it is the only way to make money)!
So I prefer focusing on low price to book stocks, even with all the problems and contradictions inherent in stated book value. The ratio is relatively unequivocal if taken directly from the audited financials, though I do like to add the ‘tangible’ twist; goodwill is not something I am fond of, accounting goodwill that is. In fact, I love Graham’s concept of net-nets with a margin of safety (66% of current assets net of all liabilities as a threshold). Unfortunately, during the past 30 or 40 years there have been few Graham net-nets out there to purchase – with the exception of that wonderful period from about November of 2008 to April 2009. I’m already waxing nostalgic!
But as to adopting a purely price to book value yardstick for making my equity investments, I have to admit that I am a bit of an aesthete – I really want something a bit more elegant. (I think I read somewhere that Walter Schloss wouldn’t tell his clients what stocks were in their account for fear that they would demand their money back on seeing such a portfolio of ‘dogs’). So I’m looking for something more…
Someone might object here that I am being far too simplistic and should instead analyze my universe of stocks by valuing their future cash flows. After all, the value of a stock is simply the discounted value of its future cash flows. Of course I should. But, alas, I simply can’t; as I’ve said before, I’m really not a believer in forecasting, and I certainly don’t think that my forecasting skills are better than those of a whole slew of Wall Street analysts. The fact is I just don’t trust myself to do discounted cash flow analyses because I believe that the outcome will just reinforce my existing prejudices; DCF analyses are a kind of self-fulfilling prophecy. Whatever revenue and expense growth rates I choose, whatever discount rate I choose, whatever other input factors I choose are based on my preexisting beliefs about the company. All of which are bound to be wrong. So lets just dump DCF, and even reverse DCF analyses, as simply too dubious. OK, OK so maybe once in a while we’ll indulge. Just not too often.
This points out what I think is one of the hardest parts of investing – accepting that you have no special insight, so you better just use the tools that you know work and focus on areas where you have strengths and, if possible, some competitive advantage. Remember, everybody else with all their fancy models and analyses is ‘average’ (taken together, that is), even if certain people, individually, are much better investors than I will ever be.
These are what I consider my competitive advantages.
- I know I’m not a better analyst than… almost everybody else
- I am investing for myself so my major goal is to increase my wealth (I’m not interested in generating commissions, keeping my job, being quoted on CNBC or helping my firm generate investment banking fees)
- I have no constraints as to what I can invest in
How I propose to exploit these competitive advantages is the subject of my next post. Then, I promise you, we’ll get into some investment ideas and I will digress only now and again on areas of investing philosophy that I am then wrestling with, like optimal number of positions in a portfolio.