Riding Coattails

In previous posts I have referenced famous investors, e.g. Warren Buffett and Mohnish Pabrai. I think it is important to study what they have to say and learn from their wisdom and experience.

But wisdom is not the only thing we can get from well-known, proven investors. From time-to-time we can get their investment ideas, more affectionately known as 'ride their coattails'. Some of my most profitable investments have come from someone else's idea.

But you must exercise caution. Warren Buffett may have an incredible track record but he is not infallible. You would be a fool to blindly buy what someone else is buying without developing your own opinion of its merits. Riding coattails is merely a starting point for thorough analysis.

There are a handful of investors to whom I pay attention. If I see their name in a headline I read it immediately. The following are a few of their names:

• Warren Buffett, Berkshire Hathaway
• Mohnish Pabrai, Pabrai Investment Funds
• Whitney Tilson, T2 Partners
• Bill Miller, Legg Mason Capital Management
• Chris Davis, Davis Funds
• Walter Schloss, retired

One problem with riding coattails is you won't be the first or only person to receive the information. So you will not have an information advantage over the rest of the market. In fact, the market will probably have the information before you. Generally, when news breaks that Buffett has been buying a stock the price of said stock jumps well before most of us could react. So, again, a word of caution: Use coattail riding only as a starting point for your analysis.

Why do these guys disclose what they are buying? It obviously could create problems for their own buying programs. The simple answer is: They are required to do so by the SEC. Bill Miller and Chris Davis run mutual funds. The SEC requires them disclose, on a periodic basis, everything their funds own. The others run hedge funds or other non-mutual fund entities. In that case, they are required to disclose to the SEC some or all of the securities holdings under various circumstances.

Keep your eyes open for news about great investors with whom you are familiar. It might lead to your next great investment.

Hope is Public Enemy Number One: An Extension of the Margin of Safety Discussion

Hope is a wonderful thing. It allows us to dream of a brighter future. Without hope, all of humanity would exist in a perpetual state of depression. A life without hope would not be worth living.

But hope, for all of its good qualities, is enemy number 1 of the prudent investor.

Hope causes us to believe a situation will improve without a reasonable basis in fact. Let's suppose, for example, we are analyzing a company that has experienced a 25% decrease in annual earnings from its all-time high. Hope causes us to shortcut the analysis by blindly making the assumption that earnings will eventually rebound to the previous highs. If we make the decision to purchase shares based solely on that assumption we become slaves to hope. We run the risk of not making money, or worse, losing money, if earnings do not recover. The only escape is to be hopeful of a brighter future.

It is certainly possible for a company to have a large drop in earnings followed by an equally large increase in earnings. But that is beside the point. The problem arises when the investor's expected return is entirely dependent upon the eventual rise in earnings. If earnings do not rise he loses money, either in absolute terms or in opportunity cost. What he needs is a backstop, i.e. a margin of safety. He has to ignore the hopeful desire for earnings to increase and only purchase shares if he can reasonably expect to realize an adequate return even if the situation doesn't improve.

When analyzing stocks, you should look for situations where you have a high probability of profit even if things do not improve for the company. In other words, buy stocks at a low enough price that even if earnings do not grow you have a good chance of price appreciation and if earnings decrease further you won't lose too much (Mohnish Pabrai calls this "heads I win, tails I don't lose too much"). Do your analysis, and make your decisions, based on reasonable case and worst case scenarios. Ignore the best case because it is the result of hope. If your expected return is not dependent on the best case scenario, but it subsequently materializes, so much the better. You exceeded your expected return. The best case scenario is nothing more than a free option to the prudent investor. GRAVY!

Value Investing Part III: Margin of Safety

Be sure to read Part I and Part II of this series.

Warren Buffett calls Margin of Safety "the three most important words in investing."

Margin of Safety is a concept originally described by Benjamin Graham in "The Intelligent Investor" (This is a must read for any serious investor. Follow the link to Amazon and buy it NOW).

Margin of Safety is an integral part of Graham's definition of Investment. It increases the probability that we will achieve "safety of prinicipal and an adequate return." Without a Margin of Safety we are not investing, we are speculating.

The process of determining the value of a stock is imprecise. It is dependent upon estimates and projections of future events. There is a high probability that even the greatest investor will make mistakes when valuing a company. To compensate for errors in our estimate of value we must purchase stocks for less than the value. For example, if I think XYZ Corp. has a value of $20 per share I wouldn't want to buy it for $20 a share. Sure, if my value estimate is spot on, I probably won't get hurt by paying $20. But the chance that my value estimate is absolutely correct is nearly zilch. As a result, I want to buy XYZ Corp. for less than $20.

How much less? The answer is completely subjective. It depends on how comfortable you are with your estimate of value and the risks the company faces that could impair its value. If you are confident that your value estimate is highly reliable and there are few risks that could impair value, then you might be willing to buy at $15. Conversely, if the risks of impairment are high you might require a price of $10 to trigger a purchase of shares. You should think of Margin of Safety as a concept rather than a specific number. The Margin required in any specific situation depends on the circumstances surrounding that situation.

Mohnish Pabrai, in The Dhandho Investor, describes Margin of Safety as buying $1 bills for $0.50. A value investor searches the market for situations where he can buy a stock for half of what it is worth and sells it when the price is at or near value. In Pabrai's words, buy a $1 bill for $0.50 and sell it when the price recovers to $1; an extremely profitable proposition. The Dhandho Investor is another book on my 'Must Read' list. Follow the link and buy it now.

What should be clear by now is the relationship between Margin of Safety and Graham's definition of investment. A larger Margin of Safety lowers our probability of permanently losing money and increases our probability of earning an adequate return. Said another way, Margin of Safety decreases risk and increases expected return.

This concept runs counter to what our emotions would have us do. When stock prices are going down, fear sets in and we want to sell. But if you believe in the Margin of Safety concept, declining stock prices is exactly when you should be buying. Because when prices are declining the Margin of Safety is going up.

Value investing is contrarian by nature. Prices go down when there are more people willing to sell then there are people willing to buy. Therefore you have to be able to operate against conventional wisdom. Warren Buffett says it best, "Be greedy when others are fearful, and fearful when others are greedy." To be a successful value investor you must be able to think independently and trust your judgement. If the prices of your stocks are going down and you are questioning the wisdom of your purchases take solice in the words of Ben Graham, "You are neither right nor wrong because the crowd agrees with you. You are right because your facts and reasoning are right."