RISK AND RETURN:
RESTATING SOME FUNDAMENTALS
FOR VALUE INVESTORS

Part VII

15 September 2003

...continued from Part VI

God helps them that help themselves … At twenty years of age, the will reigns; at thirty, the wit; and at forty, the judgment … Dost thou love life? Then do not squander time, for that is the stuff life is made of … An investment in knowledge pays the best interest.

Maxims prefixed to Poor Richard’s Almanac (1757)

Table 5: Payback Periods Under Two Sets of Assumptions

Clearly, and as shown in the right half of Table 6, an increase of both initial yield and the coupon’s rate of growth decrease the payback period, decrease risk and therefore the return on investment. At the same time, however, it is not just interesting – it is critically important – that the price at which an asset is purchased, i.e., its yield, is at least as and probably more important than its coupon’s rate of growth. Compare the right half of Table 5 and the left half of Table 6. In the latter table, a 50% increase in the coupon’s rate of growth (i.e., 15%–10% ÷ 10% = 50%) is unable to surmount the advantage of a 50% advantage in initial yield.

Table 6: Payback Periods Under Two More Sets of Assumptions

The Return on an Investment Must Be Tangible

To adopt time, i.e., payback period, as a measure of return is to measure one’s investment results in tangible terms. There must be a standard unit of measurement that enables the investor to determine whether Investment A is better than Investment B. Income that over time is either retained or paid to the investor is a sensible unit of measurement because it is tangible (see in particular Show Me the Money! Value Investing and Dividends). In sharp contrast, the vast majority of market participants – and virtually all investment vehicles, particularly managed funds and superannuation funds – mistakenly measure an investment’s return in terms of its “performance i.e., its percentage change of market price from one point in time to another (i.e., week, month, quarter, year). Indeed, in Australia and other countries there exists a “cult of performance” that has many injurious consequences (see in particular Richard FitzHerbert, Blueprint for Investment: An Approach for Serious Long-Term Investors, Melbourne, Wrightbooks, 1994, ISBN 0947351663). Alas, those beholden to the cult of performance – which includes virtually all market participants – delude themselves: an asset’s market price represents a perception of its value by market participants – not its actual value (see also Value Investing and the (Mis)Measurement of Results).

“Performance” is neither tangible nor enduring. This is painfully obvious to the many Australians who have watched the price of “their” company’s shares fall drastically in response to a seemingly good report of earnings, or who have repeatedly witnessed abrupt up-and-down movements of a stock’s price even though no material change in the company’s operations or profitability has occurred. A market is not an objective arbiter of exact value; rather, it is a forum wherein individuals and organisations exchange subjective judgments about value. These judgements, as the fall of Telstra’s share price from $8.20 in late 1999 to less than $4.00 in early 2003 shows, are as fallible as the people who make them.

Further, the fluctuations of assets’ market prices cannot serve as a measuring stick for one’s investment results because over short intervals of time (i.e., from day to day, week to week, and month to month) prices oscillate in random and often nonsensical patterns. Sometimes they reflect a sober assessment of the asset’s underlying value, but many times they do not. The relationship of a market price to an asset’s value is analogous to that of a broken clock and the time: it is correct twice a day and far off the mark most of the rest of the time.

How, then, does one gauge the return on one’s investment? By its annual coupon and the time required to recoup one’s initial outlay. One seeks the highest plausible yield and the shortest possible payback period. If you spent $4.20 per share on Telstra’s stock and if in your first year of ownership its coupon was $0.30, then the return on your investment for that year is 7.1% (i.e., $0.30 ÷ $4.20). You are repaid fully when Telstra generates $4.20 in per-share net income – measured from the time you bought it. In the interim and between any two points in time the “performance” of the stock is irrelevant. Perhaps it rallied 30% during your first year of ownership; perhaps it sank 20% or changed little. No matter: unrealised capital gains and losses (“performance”) have nothing to do with an investment’s return. Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co. puts it well: “[price] volatility is a symptom that people have no idea of the underlying value – that they have stopped playing the asset game. They’re not buying because it’s a company with certain attributes. They’re buying because the price is rising. People are playing games not related to any concept at all of what the long-term value of the enterprise is. And they know it.”

A final implication: using the assumptions set out in Table 3 (see Part V), Telstra’s payback period is 12.5 years and that of the Commonwealth Government bond to which it is compared is 20 years (given the assumptions underlying the purchase of the bond, in other words, one would have to purchase such a bond, collect its coupons, hold the bond to redemption, repurchase, etc. for twenty years before one could recoup an amount equivalent to one’s initial outlay). Telstra, then, has become more attractive relative to the bond; but in an absolute sense, and despite the fact that its price has halved since late 1999 and the yields of government bonds have fallen, it is no more attractive – and bonds are less attractive – to a value investor today than almost four years ago. More generally, most other Australian “blue chips” have become more attractive relative to government bonds during the past three years. Critically, however, in an absolute sense (i.e., in terms of a sober assessment of their payback period) they have not become more attractive to Grahamite value investors.

Accordingly, and notwithstanding the substantial fall of the prices of many financial assets in the first few months of 2003, during January-June 2003 I found it very difficult to locate additional businesses with requisite good quality and low price for Leithner & Co.’s investment portfolio. Interestingly (and, in my view, reassuringly), an analogous point applied to Mr Buffett. In Berkshire Hathaway’s 2002 Annual Report, released on 8 March 2003, he stated that “we [are doing] little in equities. [Vice Chairman] Charlie [Munger] and I are increasingly comfortable with our holdings in Berkshire’s major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don’t yet believe their shares are undervalued.”

Mr Buffett continued: “in our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of [earning] at least 10% pre-tax returns (which translate to 6% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.”

Conclusion

Benjamin Graham’s key insight is the premise that “investment is most successful when it is most businesslike. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Graham held that price is what is paid and that value is what is received; observed that over time price and value gravitate towards one another but that at any given point in time they may diverge (sometimes by a wide margin); and lamented that most people rarely recognise – and a few wilfully ignore – the fundamental difference between value and price. Value investors, as practitioners of Graham’s approach are often called, thus reject the prevailing view that the price and value of a security necessarily coincide at all times.

Value investors thus regard themselves not as traders of pieces of paper but rather as part-owners of tangible businesses. As such, they seek to:

• allocate investment capital on the basis of justifiable premises, valid logic and hard evidence – not popularity or emotion; reduce the risk of permanent loss of capital (as opposed to short-term quotational loss); be cautious when others are confident and aggressive and decisive when others are fearful;
  
  
• increase the intrinsic value (as opposed to the quoted market prices) of their portfolio of securities.

Mr Graham is widely regarded as the founder of financial analysis. Alas, his principles are rarely practised. In a speech entitled “The Super-investors of Graham-and-Doddsville” and published as an appendix to Graham’s The Intelligent Investor, his student and colleague, Mr Buffett, concluded that “the secret has been out for fifty years ever since Ben Graham and [his co-author] Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the thirty-five years I’ve practiced it. There seems to be some perverse human characteristic that likes to make things difficult. The academic world, if anything, has actually backed away from the teaching of value investing. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish.” To value investors, however, their minority status is not just moot: it is a blessing. “There will continue to be wide discrepancies between price and value in the marketplace and those who read their Graham and Dodd will continue to prosper.”

Designed & maintained by
Artist Web Design
©1999-2008 All Rights Reserved