February 3, 2023
The Intelligent Investor
US equities have historically generated outstanding returns for long-term investors. Notwithstanding numerous recessions, market panics, wars, and a global pandemic, the S&P 500 has increased in value from 17 in 1927 to nearly 4,000 in 2022, equating to an annualized total return of nearly 10%. Today, S&P 500 index funds are available to virtually everyone, with transaction costs and expense ratios close to zero. The main cost of equity ownership resides in the acceptance of constant volatility. Equities not only bounce around daily, but also decline by an average of 20% every five years or so. Most investors understand the folly of market timing and the importance of maintaining exposure to a diversified equity allocation. Still, large price movements can be uncomfortable for most investors and even unnerving for some. So, how does an investor cope with outsized volatility, particularly at the individual security level?
When confronted with investment questions, I regularly turn to Warren Buffett’s teachings for guidance. He considers Benjamin Graham’s seminal book, The Intelligent Investor, the best investing book ever written. While the book largely shaped Warren Buffett’s investment philosophy, there are two chapters in particular that he believes had the most significant impact. “Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years. I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.” Since markets have been especially weak over the past twelve months, I heeded Mr. Buffett’s advice and reread both chapters.
In Chapter 8, Benjamin Graham advises us to view the stock market as a private business partner, Mr. Market. “Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.” The twist is that your business partner, Mr. Market, is quite temperamental. When he’s gleeful about the business’ prospects, he offers to buy your stake at ever-increasing prices. When the outlook is less rosy, Mr. Market runs for the exit with little regard for the price he’s willing to accept. Mr. Graham’s metaphor illustrates how share price movements regularly drive narratives and why stocks become meaningfully mispriced.
In Chapter 20, Benjamin Graham expounds on the notion that stocks should be viewed solely as fractional interests in businesses. While the mindset of public and private investors should be similar, their behaviors are often radically different. Public securities are often viewed as flicking ticker symbols on computer monitors meant to be constantly traded. Phrases and terms like risk-on, fading, stop-loss, and 200-day moving average are part of the typical discourse. On the other hand, private business owners are much more interested in how their businesses can maximize profits in the future.
Liquidity is one of the main factors that distinguishes public from private markets. And while liquidity is an extraordinary feature of public markets, it can influence an investor’s behavior, tempting one into buying and selling based on current events. Such hyperactivity can cause investors to lose sight of what they own. An investment in the shares of Kroger should be viewed and analyzed no differently from an investment in a local grocery store. The value of both will be dictated by their future cash flow generation, however, Kroger’s shares will also be susceptible to the daily whims of Mr. Market.
While the intrinsic value (i.e. fair value) of any security is based on its future cash flow generation, predicting the future is very difficult. Unforeseen developments often occur and can impact one’s estimate of fair value. In Chapter 20, Benjamin Graham introduces the concept of margin of safety as protection against miscalculation and misfortune. A margin of safety is simply the difference between the quoted price of a security and its intrinsic value. Graham defined the margin of safety as a quantitative discount to intrinsic value mainly derived from a company’s balance sheet. Warren Buffett further built on Graham’s concept by including a qualitative business assessment. In addition to requiring an attractive purchase price, Mr. Buffett only invests in outstanding companies protected by an “economic moat.” An economic moat is a competitive advantage (e.g. cost competitiveness, network effects, switching costs, and intangible assets) that protects a business against competitive pressures, creating barriers to entry. Instead of relying solely on the convergence of price and intrinsic value as the source of investment returns, Warren Buffet depends on the business’ ability to sustainably compound value at above-average rates.
Whether quantitative or qualitative, a margin of safety minimizes the damage when an investor has erred. Price declines, however, aren’t necessarily an indication that mistakes have been made. Nor are they an unusual occurrence. There are countless great long-term investments (e.g. Nike, JP Morgan, Starbucks, Home Depot, Amazon, Apple, and Costco) that have declined by more than 50% multiple times during their lifetimes as public companies. Such wild price movements haven’t evaded the likes of Berkshire Hathaway. Charlie Munger, Berkshire Hathaway’s Vice Chairman, once stated that “Berkshire Hathaway has experienced 50% drawdowns three times in its history. I think it is in the nature of long-term shareholding… that the long-term holder has the quoted value of his stock go down by 50%. If you’re not willing to react with equanimity to a market price decline of 50%, you’re not fit to be a common shareholder.” Despite several 50% declines, Berkshire Hathaway has generated an annualized total return double that of the S&P 500 since 1965. While significant share price declines are never pleasant, even the world’s best and most financially sound companies have been subject to substantial declines. It’s an inevitability that most, if not all, stocks will encounter outsized declines over their lifetimes as listed securities.
There are undoubtedly instances when large share price declines are justified. A disruptive structural change might threaten a business’s viability, or an industry’s competitive intensity may substantially increase. Valuations might be overextended due to speculative fever resulting in a bubble. Detecting the root cause of a company’s challenge and measuring its severity is a complex task that requires in-depth research. That said, share price movements in isolation aren’t a reliable indicator of whether risks are increasing or decreasing. Nor are they reliable at anticipating unforeseen risks. Warren Buffett often states that “Mr. Market is there to serve you, not to guide you.”
Benjamin Graham’s writings are timeless, yet the strictest application of his brilliant investment principles will not eliminate the unease of a significant price decline at the index or security level. Mr. Graham’s writings, however, serve as a reminder that volatility is inextricably linked to public markets. Most of the time, Mr. Market operates as a rational business partner, offering to transact at reasonable prices. Occasionally, his behavior is anything but rational. His erratic behavior is easier to dismiss at the index level, as US equity markets have always recovered in the fullness of time. Most individual securities will decline in sympathy with broad market sell-offs; however, determining whether Mr. Market’s near-term behavior is sensible at the security level is much more challenging. Despite his shortcomings, Mr. Market’s long-term business appraisals tend to be very accurate. This idea is best encapsulated by none other than Benjamin Graham. “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”