In his 1934 investing classic, Security Analysis, Wall Street investor Benjamin Graham spelt out the difference between investment and speculation: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” I do wonder what Mr Graham would make of current stock markets. My view is that, taking his definition, these are very dangerous times for investors.
Security Analysis is a very difficult read and I would not recommend it to investors. There is plenty of wisdom in it, but it comes from an age when the make-up of the stock market and the tools for analysing companies were very different from today.
In 1949, Graham wrote a much better book aimed at the private investor called The Intelligent Investor, which is still one of the best books on investing ever written. I bought a copy of the 1973 revised edition, the last one written by Graham, in a London bookshop in the late 1990s and it has had a major influence on the way I think about investing, which has stayed with me to this day.
Unsurprisingly, parts of the book have aged, but Chapters 8 and 20, which deal with coping with stock market fluctuations and the margin of safety as the central concept of investment, are as important and relevant today as they were back in 1949. A sound grasp of the lessons here will undoubtedly serve the investor well and have major implications for how we view the stock market right now.
Stock market fluctuations
Stock markets and share prices have always moved up and down on a daily basis. Most of the time the swings are small and do not influence the emotions of investors too much. From time to time there are big upwards and downwards movements that do.
Big moves upwards make us feel good because the value of our investments is growing. Big moves downwards make us feel terrible because we can see their value disappearing. There is plenty of evidence that says we feel worse about big losses than we feel good about big gains. In other words, we are more naturally averse to losses.
Graham’s view was that market fluctuations were there for investors to take advantage of. He said that investors should see the market as a servant that they were free to use or ignore as they wished and not get too emotionally attached to big moves in the markets.
Instead they should use low prices as an opportunity to buy shares and high prices to sell them. This buy low, sell high approach is simple in theory, but difficult in practice as most investors historically have done exactly the opposite.
The key thing to really understand is that Graham was referring to low and high prices relative to an estimate of a business’s value and its future prospects. Low share prices and valuations are quite often a sign of a business that is in deep trouble and is actually a speculation rather than an investment.
Conversely, a high valuation can be justified if the business’s future prospects are bright. But if the valuation gets too high and implies a more rosy future than is realistic then the investor should take advantage of the price of the market and sell.
The margin of safety
Warren Buffett’s number one rule of investing is don’t lose money. It is highly likely that this view was formed after working for Graham in the 1950s and reading The Intelligent Investor.
Graham’s investing philosophy was influenced by his experience in the Great Depression of the 1930s where he, like many others, experienced painful losses.
The avoidance of losses is arguably the most important driver of long-term returns from a portfolio of stocks. Simple maths tells you that a stock that halves in price then has to double in price just to get back to where you were. This is not easy and is therefore best avoided by selecting an investment that protects you against this as much as possible. This is the all-important ‘margin of safety’.
Graham refers to the margin of safety in relation to two things: the price paid for a share and the quality of the business behind the share.
Graham looked at prices and valuations of stocks by referring to their earnings yield (earnings per share as a percentage of the current share price) and compared them with the yield on bonds. If a share could be bought with a satisfactory starting price and earnings yield and could be conservatively expected to grow its earnings then there was a margin of safety. But this safety would disappear if the price paid was too high and the starting earnings yield was too low (PE too high).
He correctly identified that the market had a tendency to overvalue growth stocks and “has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings”.
He also rightly identified the importance of business quality when buying stocks and explained how investors could mistake cyclical businesses with temporary high profits for quality businesses:
“...the risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at the time of favourable business conditions. The purchasers view the current good earnings as equivalent to ‘earnings power’ and assume that prosperity is synonymous with safety.”
Market fluctuations and the margin of safety in current stock markets
Since the financial crisis of 2008-09 until the middle of February this year, stock markets had enjoyed long periods of relative calm, with share prices moving higher.
This was helped a great deal by central banks across the world manipulating bond markets by printing money to buy bonds, pushing up their prices and pushing down their interest rates. So much so that the interest rates on bonds and savings accounts all but disappeared and pushed investors into stocks in search of an income return on their money.
This all worked well as long as investors remained confident in the visibility of the future earnings from companies. The coronavirus has brought this to a crashing halt.
Many companies have shut down their businesses or are seeing a big reduction in demand for their products and services. So much so that they can no longer give investors any accurate guidance on how much profit they might make in the short term.
Unsurprisingly, this has spooked stock markets and caused them to fall. But during the past couple of weeks they have rallied hard in the hope that governments and central banks will flood economies with money and make everything good again. Any whiff of a possibility that businesses might be able to open their doors again has seen big daily gains in the markets.
These current extreme levels of market fluctuations (or volatility) are good for investors who want to sell shares because they are certainly not providing a margin of safety to buy quality businesses. Graham’s view on low-quality businesses has been proved correct, with shares that looked cheap suffering massive price falls.
I see the current behaviour of stock markets as casino-like, with a dangerous and misplaced addiction to the perceived benefits of printed money.
Printed money does not offer a cure for the coronavirus. It does not alter the fact that no-one has any real visibility of company earnings, how big they will be and how they will develop over the next few years. Anyone who has run a business will tell you that getting one back up and running after closing it down is not as easy as flicking on a light switch.
Many businesses will have suffered permanent damage. Customers will have been lost and many who have lost their jobs in the shutdown will not have money to spend. Supply chains that were previously trusted have been shown to be very fragile.
The valuations of businesses need to reflect these increased risks and I don’t think they currently do.
Printed money and massive government spending is also not a free lunch. People will eventually have to pay the bill in the form of higher taxes or the reduced purchasing power of their money caused by the inflation it might create. These current euphoric stock market rallies conveniently ignore these risks.
Then we come to the prices of good quality businesses. I have argued that their valuations have been high – arguably too high – for some time now. Yet, some have provided superior downside protection because of the perceived stability of their earnings.
These earnings are not bulletproof. Customers of software companies such as Microsoft (OQYP) are likely to buy fewer licences, use cloud computing services less and buy or renew fewer software subscriptions. Few companies will escape forecast downgrades to their profitability.
Microsoft still trades on more than 30 times its last year’s earnings, which equates to an earnings yield of just 3.3 per cent. What kind of growth do you need to give a margin of safety right now?
In many cases, the valuations of quality shares have increased much faster than their profits. Low interest rates on bonds can explain some of this, but not all of it.
Two very high quality UK businesses in Spirax-Sarco (SPX) and Halma (HLMA) have seen their valuations explode over the past 15 years, and particularly in the past five as investors have flocked to them for their predictable growth. That predictability is nowhere near as good as it once was.
The valuations of both now look dangerously high. I have looked at the change in share prices that have come about from changes in the PE ratio rather than the change in earnings and ask how long can this be sustained? Where is the margin of safety?
It pains me to write something like this, but I think the world has changed. Lower visibility and higher debts for many companies needs to be reflected in lower share prices. Long-term investors should welcome this as it will provide them with the margin of safety that has been missing for too long.
