Thursday, January 24, 2013

A Behavioral Margin of Safety

                In 1991, one of the least-known, best investors of our time wrote a book called Margin of Safety. Seth Klarman, the author and Chairman of the highly-respected hedge fund, Baupost Group, did not take long to figure out that publishing was not going to be where his bread was buttered. He published only 5,000 copies and stopped printing what many value investors  now consider “the bible”. Today the book fetches $2500 a copy on Amazon but might be found used on eBay for $1000. Klarman could now likely turn a tidy profit publishing a few more copies but that clearly was not his objective in the first place. His objective was to get out of his head and on to paper what is the truth about why very few people are highly successful investors and most range from average to outright failures. Most investors, he concludes, focus on return and not risk.

                In the book, Klarman goes out of his way to focus on risk. He notes, “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

                Klarman goes on to discuss several methodologies for examining what the true value of a company is versus the perception of its value as portrayed by its stock price. He mentions many methods for evaluating the “real” value of a company -- practices which can be executed by most undergraduate-level finance students. Klarman knew that his formulas and assumptions could be perfect, but unless perception (stock price) and reality merged, he would not make money. The gap needed to be wide enough to account for uncertainties and peoples’ perceptions needed to change.

                While this all seems dull and mathematical so far, great investors like Klarman, Buffet, and Soros are acutely aware that current circumstances  and the corresponding investor behavior they elicit is what leads to any disconnect between the market price and the true value of each of their holdings. They believe that the ideal circumstance for identifying the widest gap (best margin of safety) is when the fewest number of people agree with them. This happens when the behavior of other investors is contrary to their own.  Great investors also know that extreme behavior is not permanent behavior.  Attitudes can change more rapidly than fundamentals and money can be made anticipating these attitudinal shifts.  Money can be made buying companies (or industries, or markets) with the highest “behavioral” margin of safety. Capital can be protected by avoiding (or shorting) those with the lowest behavioral margin of safety (crowded trades).

           What is also quite clear to us is that the longer an investment behavior persists (e.g. buying bonds, selling energy stocks, buying large cap growth stocks, etc.) the greater the likelihood that this behavior will sow the seeds to its own reversal.  At these "behavioral inflection points" the selling will dissipate and turn into buying and the buying into selling.  Said differently, the stocks (or bonds, commodities, real estate) with the lowest behavioral margin of safety are those that have already  gone up the most for the longest period of time.

        When I think of recent history, I think of the stock of Apple.  In September of 2012 the stock eclipsed $700 per share.  Since October of ‘08 Apple ascended to that level in a mesmerizing fashion growing at an annual rate of more than 60%.  Few managers who expected to beat their benchmarks could afford to be left out of this stock.  At $700 per share there was still a cogent argument as to why the stock had a fundamental margin of safety.  Excluding the over $120 of cash per share the company had on its balance sheet,  Apple was still trading at under 12 times its forecasted earnings. This was cheaper than many slower growing, lower quality companies in the S&P 500.  But how high was its behavioral margin of safety?  Did everybody who was going to buy it already own it?

        While this practice is difficult to quantify, I would hazard to guess that the behavioral margin of safety was not high for this investment.  According to Nick Murray Interactive, Apple was one of the top ten holdings in over seven hundred equity mutual funds; four hundred had it as their single largest holding.  400 mutual funds quantitatively demonstrated that this was the single stock that was going to help them the most in beating the market averages over the foreseeable future after it had already gone up more than just about any other stock over the previous four years.  It takes some courage to own any single company.  With Apple it took a great deal more courage not to own it.  I have no idea how this company will perform from current levels ($500 per share a/o 1/2012) but Nick Murray said it best when he commented, “We may no longer be willing to accept even excellence from Apple, because we have in some sense started pricing in magic.”

            The behavioral margin of safety for the stocks in general can vary over time. As we enter 2013 stocks have recovered over 100% from their lows in March of 2009.  One would think that the average investor increasingly participating is one of the reasons for this recovery.  This is not the case. According to Gallup, every year since the recovery began the “participation rate” of American household in stocks has declined.  The participation rate sits at 54%, the lowest level since Gallup started measuring the data in 1999.  Everybody who can own stocks clearly does not own stocks. Every dollar that could come into the stock market has yet to be committed.  We would need to see more investors behaving with impunity before waving the caution flag to our loyal constituency.