Category Archives: Margin of Safety

It should be assumed that a conflict of interest is par for the course when crossing paths with Wall Street. Therefore, we needn’t be upset or worried when companies, acting in accordance with the goals of Wall Street, conduct business in a similar fashion. As investors we need to plan our strategies around the worst outcomes that have been the result of Wall Street “activities.”

Again, this extends to corporations that play the Wall Street game. If “The Street” feels that stock buybacks are an effective way to increase shareholder value then the corporations will do it. Although we have sat in on VC meetings where the head of a company explicitly said that share buyback are worthless as a strategy for increasing shareholder value.

The creation of ETFs, which were supposed to more effectively compete with Index Funds or supplant sector funds, seems to fit the bill in this regards since there is considerable question of whether the ETFs actually hold the asset they claim to be in possession of; either stock or commodities (article here). Now, with ETFs veering away from tracking indexes and sectors while allowing “fund managers,” we openly wonder what the difference between an ETF and the product it is supposed to replace. In our opinion, the primary difference, based on SEC filings on the matter, is collecting a fee without actual ownership of an asset. Thereby rendering the small “management fee” of an ETF into super profit in comparison to the traditional mutual fund and index fund.

Thankfully, none of the products that are consumed by the retail investor are done forcibly. However, this goes back to the idea that Klarman mentions about avoiding market fads in the introduction of his book…“The important point is not merely that junk bonds were flawed (although they certainly were) but that investors must learn from this very avoidable debacle to escape the next enticing market fad that will inevitably come along (page xvii). All too often, investors ignore history which often reveals how easily a fad can take off. In the following quote, Klarman implies that a good rule of thumb on determining what a market fad is based on how long the product has been in existence, “Although newly issued junk bonds were a 1980s invention and were thus untested over a full economic cycle, they became widely accepted as a financial innovation of great importance…” (page 14). We would add to that rule of thumb by including that the more removed from actual ownership the less incentive there is to invest.

The concept of market share often leads to the belief that the other firm is going to eat your lunch. This ignores the fact that the other firm isn’t using a qualitative standard for entering into such transactions. This leads to all firms chasing any opportunity for a fee at the expense of the company, the industry and the customers.

In our approach to any investment that is made, the priority is always on the likelihood of loss. The focus on loss requires the expectation that an investment will decline in value and having a reasonable strategy in place to deal with such scenarios before the investment is made. This makes our Investment Observations seem less enthusiastic as compared to someone who might think that a particular stock is reasonably undervalued.

This is best demonstrated when circuit breakers were introduced for the New York Stock Exchange after the crash of 1987. In an ironic twist, circuit breakers were never triggered based on downside movement of the NYSE in the period from 2007 to 2009. So much for the effort to protect investors with circuit breakers. Another example of regulator bias against the downside is the requirement and/or effort to reintroduce the uptick rule for short sellers without a commensurate downtick rule for investors going long a stock.

This paragraph is the singular reason not to utilize the momentum investor’s approach of buying stocks that have made new highs. This is the method CNBC’s Cramer or Investor Business Daily’s William O’Neil tend to espouse. Whenever we seek out stocks at or near a new low, we’re trying to verify if the fundamentals of the company coincide with the price action of the stock.

In our opinion, conservative estimates, as they relate to a stock at a new 52-week high is always lower. For a stock within 10% or 15% of the high, the high is the upside limit with expectations of a downside target. For a stock at a new low, our conservative expectation is 10% to 15% higher with a target at the next lowest technical level. If the stock is 10% or 15% above the low then we conservatively expect a possible 10% increase with the downside at least to the new low level. The same could be said for expectations for any of the fundamental attributes of a company. However, we tend to use the next lowest full year figures available or worst case figures that are not in the negative. This is the way to conservatively consider the prospects of any company at the same time always mindful of the risk of loss regardless of our confidence in our conservatism.

From personal experience there is much confusion about what savings actually is. Money that is consistently put into a bank account and not touched unless there is an emergency is savings. Money that is put into a 401k and invested in a stock mutual fund is not savings. Too often the reflexive remark about contributions to a 401k is that the money is savings for retirement. The only way this is possible is if the money is put into a money market account. Anything else is investing which incurs the attribute of risk of loss.

The latter to of three things that investors should want are solely dependent on the realization of the markets that the company in question is worth either paying more for which in turn narrows the gap between share price and business value. Free cash flow reflected in the form of the dividends does not rely on the hopes and expectation of other investors. Either the dividend is paid or it isn’t.

Strong beliefs are what allow investors and speculators to hope that what they’re doing is right without proper consideration of the risks. This seems to be why many investors would rather rely on “conventional” market wisdom like diversification and holding stocks for the long term. Somehow the faith in a financially stable promise land in some far distant future is more appealing than the evidences of the past and the “here and now.” It goes without saying that financial markets have the tendency to spite long held superstitions bandied about as market truisms.

Anyone investing, or saving for that matter, that isn’t aware of economic cycles is likely to pay for investing instead of get paid by investing. Likewise, for anyone who is actually trying to save, those who understand interest earn it, those who don’t pay it.

This reflects investors fighting the last war rather than the current or future battles. The key to future confrontations lies in an intimate knowledge of the distant past. The key to the current environment is in the ability to avoid the popular strategies that have proven not to work in the recent past.

The challenge of investing of requires a basic understanding of the difference between getting a return on your capital versus a return of capital. Many investors strive to obtain high yield at the risk of either getting a return of their capital if their lucky or a return that is inferior in the long run simply because exceptionally high yields are guaranteed to last for only so long.

This is a matter that constantly lurks in the back of my mind when I hear someone comparing stocks with high dividend yields to government bonds. I worry that there may be something in the stock yield we don’t know about. On the spectrum of risk, we know that the government bond has a greater chance of being repaid whereas the stock’s dividend can be cut at any point.

The most blatant deceptions are often the most widely disseminated or misconstrued. Based on Mr. Klarman’s example, it could easily be said that the New Low Observer is among the active participants in such a farce. We don’t argue this point. We readily admit that we don’t know as much as a Buffett, Soros, Lynch or Rosenburg. What we do know is that we attempt to accept our failures and try to learn from them rather than move on to the next investment fad that we have absolutely no clue about.