Common stocks … common tendency

Remember the words of Benjamin Graham: “Most of the times common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble … to give way to hope, fear and greed.

#RidingTheRollerCoaster – 199

 

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Heroes to zeroes and vice versa

Borrowed the following from the book, “The Money Game” by Adam Smith:

Ben Graham, the classics scholar who was the dean of security analysis, started his text with a quote from Horace: “Many shall come to honour that now are fallen, and many shall fall that are now in honour.”

The markets are more powerful that each individual player. There are reputations made and shattered especially at the time of turn of events. The market cycles have the reputation of making and breaking the reputations (and fortunes) of many.

Read the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” to know about such stories ranging from Sir John Templeton, Warren Buffett, Benjamin Graham, Prof. Irving Fisher, Mary Meeker, Alan Greenspan, Harshad Mehta, Ketan Parekh, Sir Isaac Newton, Julian Robertson, Prof. Irving Fisher ….

#RidingTheRollerCoaster – 190

Valuations in the new era

In 1934, the great investment theorist Benjamin Graham wrote of the pre-1929 stock bubble:

Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

(Source: Four Pillars of Investing – Lessons for building a winning portfolio by William Bernstein)

William Bernstein writes further in “Four Pillars of Investing”, “Even the most casual investor will see the parallels of Graham’s world with the recent tech/Internet bubble. Graham’s $100 stock sold at 40 times its $2.50 earnings. At the height of the 2000 bubble, most of the big-name tech favorites, like Cisco, EMC and Yahoo! Sold at much more than 100 times earnings. And, of course, almost all of the dot-coms went bankrupt without ever having had a cent of earnings.

To see a similar pattern across time periods, across geographies and across asset categories, read the chapter on “Valuation” in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”. There were cases of such ridiculous valuations in real estate stocks in India in 2007-08, real estate prices in Japan in the 1980s, tulip bulbs in Amsterdam, technology companies in the 1999-2000 – such events have occurred at an amazingly high frequency.

#RidingTheRollerCoaster – 176

Can the Governments and regulators prevent the next crisis?

Recently I came across an article from Knowledge@Wharton. The article quotes two  professors: Wharton’s Peter Conti-Brown and Carnegie Mellon’s Allan Meltzer. I would like to highlight one point in particular that Prof. Meltzer talked about..

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future …”

At the same time, they discussed that the only way is to increase the bank’s own capital. The skin was not in the game for the banks. Many banks were hugely leveraged. Though the banks are required to maintain a capital adequacy ratio, many banks took off-shore routes to register their SPVs (Special Purpose Vehicles) and heavily used derivatives. Lehman Brothers, the famous failure of the 2008-09 crisis had more than 50 times leverage.

There are so many instances referred in the book:

  • Benjamin Graham later said that the mistake was that he owed money.
  • The leverage at LTCM was way too high. At some point, it was more than 50 times the capital. Leverage can enhance returns when the cost of borrowing is lower than the return on investment. However, when the returns are poor, the cost and the liability of repayment can be detrimental.
  • Easy availability of cash (foreign capital, easy credit, leverage – in whatever form) is one of the common factors among all the market frenzies.
  • Leverage used to invest in illiquid assets also poses a risk. Once again, if you do not have an alternative cash flow and the asset is illiquid, repayment of borrowed capital becomes difficult.

I have just highlighted a few from the book.

Two important points here: Every crisis looks very different in the beginning. This happens since we keep looking at the events that happened without understanding the lessons. We keep looking for the old crisis to happen again from the same place. Government and the regulators are no different.

The crisis is not new. It just crops up from somewhere else.

#RidingTheRollerCoaster – 171

Overconfident Enemy In Mirror …

Came across this superb article by Larry Swedroe, titled Overconfident enemy in the mirror.

It highlights the folly of getting overconfident in a field that is full of uncertainties – investments.

Nothing can be achieved if one were not confident about one’s abilities, since lack of confidence would lead to a person not even trying new things. At the same time, it is also important to understand that success also eludes those who do not know about their own limitations.

It is for nothing that Warren Buffett says, “Invest within your circle of competence. It is not how big the circle is but how you define the parameters.” Do we even know the parameters? This is an important question to consider.

In the absence of the knowledge of the right parameters – what can lead to success, we wrongly assume the short term result to be the parameter of success. We mistakenly focus not on the process but the results – and that too short term results.

And that often leads to overconfidence if the short term results are positive, or in line with expectations. This leads to behaviour that is harmful to our own future. And that exactly is what Swede highlights in the article. Remember the words of the guru of investing, Benjamin Graham, “The investor’s chief problem and his biggest enemy is likely to be himself.

#RidingTheRollerCoaster – 159

Ben Graham’s classic books

I believe it was the experience of the boom and bust of that period, which Benjamin Graham brought out in his 1934 classic “Security Analysis” and the subsequent book “The Intelligent Investor”. Warren Buffett described the latter as the best book on investing ever written.

#RidingTheRollerCoaster – 87

 

Beware of leverage

Recently, I read an interview of Mr Rajeev Thakkar, CIO of PPFAS Mutual fund in the Value Research magazine. Somewhere in the interview he mentioned, “… leverage in the wrong hands can be devastating.”

During the great depression, a young investment professional  – Benjamin Graham – used too much leverage. This was a combination of leverage and a crash in the market. His portfolio hugely underperformed the overall market.

Graham corrected his mistake subsequently and emerged a winner. Graham eventually came to be known as the “Father of investing”. One of his disciples, Warren Buffett, earned more fame than the teacher.

After his disastrous experience as an investor during the great depression, Graham said that the mistake was that he owed money. “I didn’t repeat that after that.“, He said.

Leverage is not bad by itself, too much of it is disastrous.

#RidingTheRollerCoaster – 62