Whither the Economy?

Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.

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What Makes a Good Business?

Seth Klarman, clearly one of our favored sources of investing insight, recently took up the task of revising Benjamin Graham and David Dodd’s famous Security Analysis. In the introduction, Klarman observes some of the persistent difficulties in the stock market that enable some investors to generate outsized returns. One such difficulty is the lack of clarity about what makes a good business.

Klarman writes: “Another area where investors struggle is trying to define what constitutes a good business. Someone once defined the best possible business as a post office box to which people send money. That idea has certainly been eclipsed by the creation of subscription Web sites that accept credit cards. Today’s most profitable businesses are those in which you sell a fixed amount of work product–say, a piece of software or a hit recording–millions and millions of times at very low marginal cost. Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow.” (xxxv)

All told, a very useful set of criteria.  The only thing I would want is some additional criterion about increasing margins.  In highly competitive industries, some businesses find it difficult to raise prices, since their market share quickly drops when they do.  A good business has customers who are relatively unconcerned about marginal price increases.  Businesses that have this privilege include Coca-Cola, Moody’s, Mastercard, and Visa.

Case in point, at the football games this past fall, a Coke was selling for $5 a cup.  And let me tell you, you still had to wait in line to get it.