Market Ineffeciency

Value investing is based on the availability of mispricing of securities. It is important to understand the source of these inefficiencies. The financial market today is dominated by professionals that manage money for other individuals and institutions. It is the institutional imperative of these professionals that give rise to most of the market inefficiencies from time to time. One of the best explanations of this imperative I have read is by Jeremy Grantham at GMO in his letter to investment committee in Oct 2004:

Everything important about markets is ‘mean reverting’ or, if you prefer, wanders around a trend. Prices are pushed away from fair price by a series of “inefficiencies” and eventually dragged back by the logic of value.

In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes “keep your job.” Career risk reduction takes precedence over maximizing the clients’ return. Efficient career risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because others are buying.

Prices are eventually pulled back to fair price by the need for the return of each asset class to relate sensibly to its risk. This is the force that exercises a persistent gravitational pull on inefficient prices and this force is generally described as ‘value’. An investor in equities in the ultra cheap markets of 1982 or 1945 who is receiving 10% or 20% a year real return for owning equities will sooner or later get a lot of company to bid down the returns. Conversely, all investors in 2000 faced with a market p/e of 33x, and an embedded return of under 3% a year while bearing full equity risk, will eventually lose heart and sell. A mix of behavioral inefficiencies and value based efficiencies means that bubbles will form and all of them will break.

The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly. So at extremes you will always know what will happen but never when. You will know something certain about the indefinite future, but usually nothing material about the immediate future. This is why asset class prices resemble feathers in a hurricane – all certain to hit the ground, but lord knows when. If the timing was also knowable, it would be an arbitrageable situation: if you knew what would happen and when, then, like a Star Trek “paradox,” it would be anticipated and could, therefore, never occur.

But not knowing the timing creates critical career and business risk, which has molded the business of investing. If you are smarter than most and want to take no career risk, then anticipate other players and be quicker and slicker in execution, or as Keynes said, “beat them on the draw.” Refusing on value principles to buy in a bubble will, in contrast, look dangerously eccentric and when your timing is wrong, which is inevitable sooner or later, you will, in Keynes’s words, “not receive much mercy.”

The more the investment industry has become specialized and the more carefully benchmark deviations are measured, the greater the career risk of moving outside your narrow style. This has weakened the arbitrage mechanism and guaranteed increasingly larger and longer market distortions. Today the challenge is not getting the big bets right, it’s arriving back at trend with the same clients you left with, and GMO, for sure, has not solved this problem. The key investment task is to structure a firm where you can make more of these long-term mean reverting bets and live to tell the tale.

The good news is that human nature, which leaves its mark on all financial markets, will never change and we will always have these great opportunities to make money and have dangerous careers.

Or if you prefer serious brevity ...

Waiting for the Right Pitch

This discipline is one of the most important characteristic that distinguishes the value investors from other market participants and the value pretenders. Here is an extract from Seth Klarman's Margin of Safety Chapter 6. By now, you can tell that I am huge fan of this book. This is the equivalent of Ben Graham's Security Analysis updated for the current times, and the lessons I have learnt by reading and re-reading this book over and over again are invaluable.

Warren Buffet uses a baseball analogy to articulate the discipline of value investors. A long-term oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle-an undervalued investment opportunity

Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky

Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if the umpire were calling balls and strikes - mostly stikes - thereby forcing them to swing at almost every pitch and forego batting selectively for frequency. Many individual investors, like amateur ballplayers, simply can't distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do

For a value investor a pitch must not only be in a strike zone, it must be in "sweet spot." Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift his bat from the shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn't want to settle for an investment offering a safe 10% return if you thought it very likely that another offering an equally safe 15% return would materialize soon.

An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. This dual discipline compounds the difficulty of the investment task for value investors compared with most others.

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines. When attractive opportunities are plentiful, value investors are able to sift carefully through all the bargains they find most attractive. When attractive opportunities are scarce, however, investors must exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid. Above all, investors must always avoid swinging at bad pitches.

Margin of Safety

So, how exactly do we implement Buffet's Two Rules of Investing. This brings us to another important concept of value investing called "margin of safety". I am quoting from Chapter 6 of the book "Margin Of Safety" by Seth Klarman:

Benjamin Graham understood that an asset or business worth $1 today may be worth 75 cents or $1.25 in the near future. He also understood that he might be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error (of estimation of value), bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, "The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some higher price."

Buffet described the margin of safety concept in terms of tolerances: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is the margin of peril

Buffet, in his 1990 letter to shareholders, says the following:

In the final chapter of the book The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Contronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right words. The failure of investors to heed this simple message caused them staggering losses ...

Buffet's Two Rules of Investing

Once we understand how to think about the market using Ben Graham's Mr. Market analogy, the next important lesson, I believe, is to remember Warren Buffet's two rules of investing.
1) Never lose money.
2) Do not forget the first rule.

To appreciate these rules better, I am quoting from Chapter 5 of the book "Margin Of Safety". This book is rare and out-of-print. It is written by another legendary value investor, Seth Klarman. So here is what is says:

Avoiding loss should be the the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of capital.

While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

Greedy, short-term oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling. Table below shows the delightful effects of compounding even small amounts. Shown below is the compounded value of $1000 invested at different rates or return and for varying durations.

Rate	5 years	10 years	20 years	30 years
6%	1338	1791	3207	5743
8%	1469	2159	4661	10063
10%	1611	2594	6727	17449
12%	1762	31p6	9646	29960
16%	2100	4411	19461	85850
20%	2488	6192	38338	237376

As the table illustrates, perserverance at even relatively moderate rates of return is of utmost importance in compounding your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90 percent of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance (and hence value investing) is not the primary focus of most institutional investors.

Ben Graham's Mr Market

This is my first post on this blog. I hope to use this blog to put in written words lessons I am learning about finance, investing, economics, and multi-disciplinary thinking. No better place to start than with one of the most important lessons, in my opinion, of investing.

Warren Buffet, the legendary value investor, in his 1987 letter to shareholders has said the following:

Whenever Charlie and I buy common stocks for Berkshire's insurance companies we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satifactory rate. When investing, we view ourselves as business analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotation. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of immenent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him

Mr. Market has another characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cindrella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market you don't belong in the game. As they say in poker, if you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: In the short run, the market is a voting machine but in the long run it is a weighing machine. The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.