Personal Investing Now
posted by Lawrence Cunningham
People are wondering about personal finance. Many ask me: is now a good time to apply time-tested principles of value investing, buying stocks at low prices compared to long-term value? Maybe, but one must be cautious as a practical matter; curious persons may also be interested in a bit of value investing history.
The most famous value investor, Warren Buffett, wrote to his fellow Berkshire Hathaway shareholders in 1986:
“Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
[The quote appears on p. 157 of my collection of Buffett’s letters, The Essays of Warren Buffett: Lessons for Corporate America (2nd ed. 2008).]
Recent Buffett investments may suggest he is attempting to be greedy now amid prevalent fear, with recent large capital allocations to Goldman Sachs ($5 billion) and Constellation Energy ($5 billion) and a smaller one in BYD, the Chinese battery maker ($230 million). But he said that the prudence of his Goldman investment depends on Congress passing legislation authorizing government intervention in the crisis. Congress failed to do so yesterday but promises another try.
Those asking me for personal financial advice can expect two broad sorts of thoughts. Both start with the caveat that financial decisions are personal and depend on characteristics of a household’s budget (like cash flows, income statement, balance sheet, the age and number of its members). But general principles may be stated and a broader point about value investing may be of interest.
First, value investing requires business judgment, diligence and competence. Value investing also requires having excess cash (beyond any allocated to vehicles like 401(k) or 403(b) retirement plans). Today, excess cash is only that available after retiring all outstanding household debt.
With debt paid off, a meaningful amount of cash should be held, enough to sustain a household for 2-4 years, discounting expected income by the probability of job loss during that time. A small portion of that cash may be held in currency in a safe box at home, an amount up to $100,000 (the amount of current FDIC bank account insurance) in bank accounts, and any remainder in money market funds (now protected by a recent Treasury insurance program).
Only if cash remains after retirement plans are funded, debt retired and liquidity established, should an investor consider allocating capital to equities. If cash is so available, applying the contrarian greed-fear principle may be prudent.
This requires estimating the fundamental value of a business and comparing that to its prevailing stock price. If there is a large margin between them, the investment may be intelligent. A sufficient margin of safety may be paying a price about half the estimated value.
Second, worth the personal investor’s attention is a broader point about where value investing came from. It, and the quoted fear-greed contrarianism, is due to Benjamin Graham, author of The Intelligent Investor and co-author, with David Dodd, of Security Analysis. Graham, who invested for decades, including the period before, during and after the 1929 stock market crash and Great Depression, made, lost and remade a fortune applying that and kindred value investing principles.
Graham’s books were responses to the undisciplined character of investing that pervaded the roaring 1920s. That period has parallels to our own. These include limited appreciation of investing as applied fundamental business analysis and expanded indulgence of financial speculation using esoteric abstractions.
Today’s abstractions include credit default swaps; securitized asset backed securities, including mortgage backed securities; collateralized debt obligations; interest rate and foreign currency exchange swaps; and other financial derivatives that extensively separate instruments from enterprises. Even individual investors became exposed to such exotica through mutual fund and similar vehicles.
These devices, in turn, expand on contemporary abstractions contained in modern finance, including the efficient capital market hypothesis, modern portfolio theory and capital asset pricing model. All these ideas are in tension with value investing and some imply it’s impossible (asserting instead that a stock’s price is the best estimate of its value and investing involves assembling a diverse portfolio of offsetting positions).
But, in times of market stress like today, none of these models appears robust; many of the financial instruments they’ve spawned are worthless and causing a cascade of staggering financial losses threatening the entire real economy. Value investing is vindicated.
Many took Buffett’s capital commitment to Goldman as a sign of a value investor’s confidence in systemic stability. But his statements about requiring a Congressional bailout, as well as the tailored and protective terms of the investment, should signal need for value investors to exercise even more cautiousness than the philosophy inherently requires.
So it may be premature to become greedy, despite others being fearful. Fears may deepen, for nothing on the horizon, other than Congressional action, suggests reasons why fears may soon abate. That is why, if I were in Congress, I would vote for the bill. And that’s also why, as a value investor, I’m studying fundamentals of selected businesses with a view towards buying undervalued stock if the bill passes.
September 30, 2008 at 9:20 pm
Posted in: Current Events
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Responses (1)
Kenneth Younger - September 30, 2008 at 11:06 pm
GREAT, GREAT book. This was one of the two main texts for my senior year valuation class in undergrad where we managed 200k in public equities. It is a book I try and read at least once a year now. I now only expect this fall’s students to be on the lookout for some good buys
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