Is this Buffett goof up costing you tons of money?
(Jan 8, 2015)
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In this issue:
» India now the 9th largest stock market in the world
» James Grant on why all this easing will end in tears
» Market roundup for the day
» ...and more!
Charlie Munger, Buffett's right hand man and the one who many consider as smart as or even smarter than the Oracle of Omaha has given a lot of nice phrases to the investing world. One such Mungerism is where he describes the secret of success. It goes thus, "Take a simple idea and take it seriously".
Well, we don't know about others but boy Buffett took one particular idea seriously or what! So much so that it made him the second richest man in the world and still going strong! Ironically, it was Munger himself who gave Buffett this life changing idea
You see, before Buffett had this chance meeting with Munger, Buffett's investment philosophy had Benjamin Graham written all over it. And why not? With Graham himself taking a young Buffett under his wings, Buffett soon became one of the foremost practitioners of the art of buying Graham type cheap stocks and then selling them off at a neat profit.
But as his friendship with Munger grew, he began to realise that Munger's approach to investing was unlike Graham's and by extension his own. Undoubtedly Munger was also a value investor, but he didn't like the idea of buying cheap, cigar butt stocks. He was more of the view that some good quality businesses are simply worth paying more for as long as one is getting a huge long term advantage.
Of course, given the high esteem with which he held Graham, it was impossible for Buffett to change his strategy overnight. But as time passed, he increasingly started realising the powerful forces at play when one buys into companies with tremendous competitive advantages.
While we don't know when the total transformation happened, Buffett's purchases of stocks like American Express and See's Candies did point to the fact that the metamorphosis was indeed complete. Munger was finally able to move Buffett totally away from Graham. And also to convince him the virtue of paying a fair price for a good business rather than a good price for a fair business.
Not that Buffett is complaining. We doubt whether Buffett would have been able to amass the kind of wealth he has had it not been for the force of Munger's mind.
So far so good. However, that's one important point we believe we forgot to highlight here. And it has to do with the fact that both Buffett and Munger are super smart guys. Between them, they have perhaps out-read and out-analysed almost all of the investing fraternity out there. Consequently, their ability to analyse a business and identify its strengths and weaknesses is perhaps unparalleled. They seem capable of drawing connections we can't even start to imagine.
Therefore, blindly aping their approach without the adequate study is a recipe for disaster we believe. A company that you think has great competitive long term advantages may not be that strong after all. For all you know it may only be riding a favourable business environment and the premium valuations you paid for it for its moat like qualities may end up burning a huge hole in your portfolio when things unravel.
Why go anywhere else, we ourselves have recommended a few stocks that we felt had durable competitive advantages but those vanished as soon as the good times for their respective industries ended.
What also didn't help matters were Buffett's new found reservations about Graham's style of investing. In fact he has been seen coming around to the view that the Graham approach or the cigar butt approach as he likes to call it, may not be worth the risk after all. Of course one gets a fabulous entry point but in a difficult business, no sooner is one problem solved than another surfaces.
What Buffett is saying is indeed true but did he goof up by talking about the specific rather than the general? In other words, taken in isolation, cheap, cigar butt stocks indeed carry higher risks. However, as a group, there could be a sizeable portion amongst them that turn around and end up giving huge returns to investors.
At least this is what Graham ended up doing and with great results, generating nearly 20% per annum by investing in cheap hated stocks over a period as long as 30 years!
As a matter of fact, a lot of other studies have come away with the same conclusion. The biggest by far was the one conducted by noted analyst James Montier who monitored a global basket of stocks such that almost all of them traded below their liquidation value. And how did it perform? Well, the strategy returned a whopping 35% per annum between 1985 to 2007! Indeed, almost anyone would be willing to be a part of such an outstanding long term record.
One group who would closely identify with this is our subscriber base of a recommendation service we've created exactly along these lines. We seek to identify the cheapest stocks out there based on financial parameters like book value or earnings and also a strong balance sheet.
And how has this service done so far? While these are still early days, the service is up a cool 47% as against the 35 odd percent that the Sensex has returned during the same period. Had it not been for the fact that we are more than 40% in cash on account of lack of decent opportunities; the returns would have been even higher we guess.
So it looks like the evidence is clear. Instead of doing the hard work of finding moat like companies which is not an easy task mind you, investors seem much better off buying a group of cheap, hated stocks that have strong balance sheets.
Please note that we are not saying that going the moat way of investing is wrong. It's just that it's a slightly more nuanced way of investing and may require higher skill sets than an investor thinks he is capable of.
What do you think? Do you think a basket of cheap stocks with mean reversion in their favour is an easier and less risky task as compared to identifying moat in companies? Let us know your comments or share your views in the Equitymaster Club.
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A little over a month back, the Indian stock markets crossed two important landmarks. Not only did the BSE market cap cross Rs 100 trillion but it also became the 9th largest country in terms of market cap. Today's chart of the day helps put India's market cap in perspective with other large stock markets across the globe. It should be noted that it took us all these years to achieve the market cap of close to US$ 1.6 trillion. However, if things go as per plan, we can easily add the same number to our current market cap in as short a time as 5-6 years. And if valuations expand then maybe in even lesser time. This could perhaps help take us past Canada and make us the sixth largest in the world. Mind you, becoming the third or fourth largest is also not out of bounds and with good support from reforms and other pro-growth measures, we have a realistic chance of being there in the next 10-12 years. Little wonder then a good portion of your savings have to be in equities in case you want to earn strong double digit returns over the long term.
India 9th largest in the world in terms of market cap
Even though US seems to be done with easing and is mulling over an interest rate hike now, the economy continues to be haunted by ghosts of QE. The massive dose of liquidity that was Fed's tool to engineer an economic recovery has failed miserably and has done more harm than good. And this was evident when it was resorted to for the first time. Yet, central bankers, instead of coming up with better solutions, chose to go for a second round and then the third, deepening the crisis.
The other economies - Europe, China and Japan, instead of learning the obvious lessons followed the lead, leading to similar outcomes - massive debt, stretched balance sheets and zero, or in some cases negative interest rates. With increased economic coupling and little firewalls, the global economy is more prone than ever to a financial crisis, likely to be bigger than the ones in the past. And how do you think central banks will respond to that?
Well, here is what James Grant, the editor of Grant's Interest Rate Observer and a well respected voice on economic and financial matters has to say. The central banks will resort to more money printing, and in the process will destroy the wealth of bondholders. Needless to say, the outcome is going to be a crisis, bigger than ever before. Keeping things in perspective, we believe we are lucky to have Mr. Rajan who believes in economic stability rather than using monetary policies as a tool for short term economic recovery!
Meanwhile, the Indian stock markets continued to trade firm after opening the day on a positive note. At the time of writing, the benchmark BSE-Sensex was trading higher by about 295 points (-0.1%) with stocks in the realty and FMCG segment leading the gains. Most of the Asian stock markets were trading higher, while majority of the European markets opened on a firm note.
"Obvious prospects for physical growth in a business do not translate into obvious profits for investors."- Benjamin Graham
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