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Friday, December 27, 2013

More on Benjamin Graham and Uncertainty

So in Uncertainty and the Margin of Safety, I suggested that an important concept in physics ought to be applied to investment analysis (and economics for that matter). Furthermore, I suggested that Benjamin Graham's concept of "margin of safety" was linked with this idea of uncertainty.

Today I want to take a closer look at the sorts of uncertainties faced in investment analysis and how Benjamin Graham recommend one face those uncertainties.

1) Start with what's most certain

One recommendation that frequently comes up in the writings of Benjamin Graham is to start with what's most certain. For common stocks, this was the balance sheet. In particular, this was the top of the balance sheet.

Concerning the Balance Sheet, Graham has this to say (from Security Analysis, Chapter XLIII):
The first rule in calculating liquidating value is that the liabilities are real  but the value of the assets must be questioned.
So Graham treated the liabilities as certain. But I think Graham would be far more conservative if we were dealing with the liabilities of a financial company such as insurance where the liabilities are actuarial estimates. But the main point here is that any money owed is definitely owed.

The assets, however, may not be worth what the stated book value says they are worth. Graham begins by treating the cash as known with certainty. However, as soon as we move to things like receivables and inventories the matter is up for debate.

Since receivables may be paid or not paid, we should discount these. Likewise, since there's no guarantee that we would be able liquidate the inventory for the stated value we should discount these as well. This all has to do with the fact that these assets have a less certain value.

Last up are the company's other assets such plant, property equipment and so on. The question is how much are each of those worth?

Consider the company's real estate? While things like land can sell fairly easily, the structures on that land will vary quite a bit. How often do you see a factory that closed down and the building sits there, unoccupied for years to come? In many cases, when the property does get purchased, the previous building is torn down or significantly modified.

Then there are things like intangible assets which may very well have a value but it's hard to put a precise figure on these.

But I think Graham's preference for the balance sheet (particularly the top) was due to the fact that we should start with what's most certain and then proceed to value the less certain aspects of the business, discounting to the extent that we don't know.

2) Never forget that the future is uncertain

One thing that Benjamin Graham never forgot to remind us was to be cautious about predicting the future. The fact of the matter is that we don't own any crystal balls (although I'm sure you can buy one . . . no promises on it working) and a lot can go wrong between now and even next year.

So how do we deal with the future?

As noted above, Graham liked the things that were most certain best. Those were the assets that one could liquidate relatively easily in a short amount of time. But even liquidation has its problems. It could take time to convince management to liquidate the assets and by the time that occurs, those assets might be worth less by then.

What about predicting future earnings?

Like Keynes (see Keynes on Investment, Speculation and Uncertainty Part I), Graham adopted the convention of relying on past performance. Sure we know the future won't be like the past but that may be the best guide we have. At a minimum, we shouldn't expect the future to be too much better than past results.

But Graham made a further caveat, which I'll quote at length (from Security Analysis, CH I):
It is manifest, however, that future changes are largely unpredictable, and that security analysis must ordinarily proceed on the assumption that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis. Hence this technique is more useful when applied to senior securities (which are protected against change) than to common stocks; more useful when applied to a business of inherently stable character than to one subject to wide variations; and, finally, more useful when carried on under fairly normal general conditions than in times of great uncertainty and radical change. (emphasis added)
I interpret this to mean that we can get away with making this assumption when this assumption will be, all else being equal, a reasonable predictor of the future. While Graham suggests this may not work well for common stocks, it may be OK for companies with more stable business conditions.

So this might be more appropriate for companies that sell noncyclical consumer goods that are regularly purchased versus. Contrast that with technology companies whose survival depends on constant innovation and we should be cautious about how well the past will be a good predictor of future profits.

In either case, proceeding with caution is appropriate. To quote Graham further (from Security Analysis, CH IV):
For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement.
So never forget that the future is uncertain.

3) Estimating a precise value is not necessary for good judgements

As I already noted in Uncertainty and Margin of Safety, valuation is not terribly precise. Models typically require a number of inputs, many of which are mere assumptions, in order to estimate the value. But knowing these figures precisely is not required for investment purposes.

Benjamin Graham gave the following consideration (from Security Analysis, CH I):
It needs only to establish either that the value is adequate - e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.
Benjamin Graham gives the example of J. I Case. Here are its earnings per share for the years 1923-1932 (taken, again, from Security Analysis, CH I).

Earnings varied quite a bit year to year. While Graham did not include a standard deviation figure, it's obviously pretty high. He calculated the 10 year average (inspiration for Robert Shiller's Cyclically Adjusted PE (CAPE)) but notes that (from Security Analysis, CH I):
the average [ . . . ] is obviously nothing more than an arithmetical resultant from 10 unrelated figures. It can hardly be urged that this average is in any way representative of typical conditions in the past or representative of what may be expected in the future. Hence any figure of "real" or intrinsic value derived from this average must be characterized as equally accidental or artificial.
As a result, simply applying a multiple of, say, 10x average earnings (about \$95) wouldn't be warranted.

Graham suggests that the best we may able to do is to give a more or less distinct estimate of intrinsic value (from Security Analysis, CH IV):
Our notion of the intrinsic value may be more or less distinct, depending upon the particular case. The degree of indistinctness may be expressed by a very hypothetical "range of approximate value," which would grow wider as the uncertainty of the picture increased, e.g., \$20 to \$40 for Wright Aeronautical in 1922 as against \$30 to \$130 for Case in 1933. It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside either the maximum of minimum appraisal.
So even if we don't have a precise estimate of the value of the stock, we may still be able to make a judgement as to whether a stock is over or under priced depending on whether it's far above or below our "range of approximate value" for that particular stock.

4) Have an adequate margin of safety.

This leads to a conclusion based on the ideas that Graham has laid out. While I'm not sure if he explicitly said so (if you have a quote, please provide!), I do think this is a reasonable extension of his recommendations.

My suggested extension is that the margin of safety required for a security or trade (this would also apply to various arbitrage-like trades) is that it depends upon how "distinct" or "indistinct" your valuation of the asset/trade is.

So trades in which the outcome is known with a high degree of certainty (such as a pure arbitrage play) would require little to no margin of safety as there's little to no room for error. On the other hand, if we're dealing with a stock like J. I. Case, we may need a much greater margin of safety to allow for the fact that the future could turn out very different than any estimate we might make of it (say by looking at past earnings).

In other words, if we're looking at Graham's example of Wright Aeronautical, which Graham puts at \$20 to \$40, if it's trading below \$20 that may be an adequate margin of safety. On the other hand, a company like J. I. Case, which Graham pegged somewhere between \$30 to \$130, we'd need to buy below \$30 to make sure we were set.

Closing Remarks

So there you have it. Reality is very uncertain and especially so in the investing world. The key is to be on your guard, acknowledge what you know and don't become too overconfident in things you don't know.

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