How to Reduce Risk: Comfort Comes from Owning the Right Business

by Geoff Gannon


Quan here.

Someone who reads the blog sent me this email:

Hi Quan,

I like your interpretation of margin of safety. I normally do not care about market volatility affecting the price of a stock. I do find myself wondering now if perhaps it is a little too dangerous to play at all. The global macro situation is at a point that it has never been before while we are always at a point that we have never been at this time the abyss appears to be particularly dangerous. At some point we are going to jump in. I think that the current global situation severely diminishes predictability. While it is also true that the markets have always bounced back the situations that they have bounced back from have never even been close to this magnitude. I realize that suggesting sitting on the sidelines for some time is counter culture to a blog on investing (I apologize) and would be interested in reading your thoughts on this subject. While never certain I feel that predictability is at or close to a low point.

We live in interesting times.

Barry

This is a question I once thought about. I started learning about value investing in late 2009. I think that I was lucky to start right after a crisis. I had the opportunity to learn a lot of lessons. And everyone’s fresh memory of the crisis also helped me to define my investment style.

I saw that the stock market had almost no return in the decade ended in 2009. And I wonder how investors can earn great returns in the long run. I remember there was an idea in my macroeconomics class that there’s a recession every decade. I thought I would wait for a recession and buy stocks, and keep them for less than 5 years. I thought maybe that’s how value investors make money. They go against the crowd. They buy stock when people are afraid.

I guess you’re laughing at me. But those were my naïve thoughts when I started.

 

Cheap = Margin of Safety

Now, I think value investors totally ignore macroeconomics. We are not economists. Predicting the future is out of our circle of competence. We just buy something when we think it is cheap. But “cheap” is not well defined. To value investors, cheap means margin of safety.

 

My View on Margin of Safety

When it comes to buying stocks, I see only two areas to find a margin of safety. One is buying net-nets. Two is buying perfect companies at fair to great prices.

If you want to learn more about buying net-nets, you can visit blogs like:

Oddball Stocks

Whopper Investments

There are even some net-nets in very good businesses. My problem with even the highest quality net-nets is that they don’t usually offer a high yield on my investment, which I define as normal earnings divided by share price. I tend to think of the worst case that some catalysts never comes. But this is the irrational part of me.

So, I normally don’t buy net-nets. I don’t buy stocks that people usually consider cheap. I don’t buy low P/E, low P/S, or low P/B stocks if the companies don’t get a high return on capital. Even if a stock has a low P/E and earns a good return on capital, I won’t buy the stock unless I think the high return on capital is sustainable or capital allocation is good. For imperfect stocks, something can always happen and delay price appreciation, which reduces my average returns. Or my mental weakness can lead me to selling at the wrong time.

So, I tend to look for stocks that I can make an adequate return if I hold it forever. That approach provides me more comfort because I don’t have to always look at the stock price to decide whether to sell. All I know is that the intrinsic value of the company is compounding no matter where the stock price is.

 

Think Like a Businessman

One of my favorite quotes from Warren Buffett is:

I am a better investor because I am a businessman and I am a better businessman because I am an investor.

When I think like a businessman, I care only about the business, not the stock price. And I think as if I own and run the company. A lot of managers have been running a company as owners and gave shareholders great return in the long run. If we think they are doing right, why shouldn’t we be their shareholders?

Why shouldn’t we be Gerald Shreiber’s fellow shareholder at J&J Snack Foods (JJSF) if we can buy the stock at the right price?

This is Tom Russo’s approach. He looks for low agency costs. He likes to invest in businesses run by founders and their families. And he likes to hold these businesses forever.

 

Buy at a Good Price – Be Comfortable with a Depressed Price

So, I mostly sit on the sidelines. Not because of the economy being in crisis but because of the lack of ideas. I just buy when I see the price is right. When I find the right company, I hope the price keeps going down.

Why?

First, I’m young. My investment horizon is long, and I don’t spend much. I’m a net buyer. And I just buy more stock when I have money. The opportunity to buy doesn’t appear often. So, I don’t want the opportunity to vanish by the time I get more money to buy stocks. I want the stock price to keep going down so I can buy more shares at lower prices.

Second, I’ll still get richer even if I don’t buy more stocks. That’s thanks to share repurchase. Good capital allocation means keeping a strong balance sheet, reinvesting if there’s a chance for profitable growth, and returning cash to shareholder if not. Then how will they return cash to shareholders? I don’t want to pay tax, so I prefer them to buy back shares. But I don’t want them to buy back expensive shares. I want them to increase my ownership at cheap share price.

The author of valueprax asked me on Twitter the other day whether DreamWorks (DWA) destroyed value when they bought back share at around $40. My answer is I don’t know. I can say the stock is cheap at $18. It’s hard to say if the stock is overvalued at $40. It’s easier to say the stock is expensive at $72. I wish the stock price stays below $20 forever. If they buy back shares at that price for years and years - I can imagine someday being the only fellow shareholder of Jeffrey Katzenberg.

Like Buffett told Joe Kernen of CNBC when Buffett announced his $10 billion investment in IBM (IBM):

Yeah. And, Joe, there's nothing wrong with fewer shares outstanding

 

Focus on What Matters

To sum up, I don’t care about the stock price going down. I care about whether the intrinsic value of a company is going up enough. I care about the business fundamentals. For DreamWorks, I care about their process to make new movies, their distribution deal, the transition in the home entertainment market, and Katzenberg’s health.

Actually, I think the two things that matter most in buying DreamWorks are Katzenberg’s health and whether the stock price is low enough.

Katzenberg’s health is fine. My special concern for keeping Katzenberg at the helm of DreamWorks is based on the simple fact that there have really been only 4 periods of clear, consistent economic value creation at an animation studio:

  • Walt Disney at Disney (DIS)
  • John Lasseter at Pixar
  • Jeffrey Katzenberg at Disney
  • Jeffrey Katzenberg at DreamWorks

Animation is not a business any idiot can run. So what matters can be different from company to company. For an investment in DreamWorks, management matters a lot. 

Talk to Quan about Comfortable Investing