Keynes and the Market Part 4

Chapter 8

Searching for Stunners

The d.a.m.n ' d South Sea The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the .ct.i.tious value must be a loss to some persons or other, .rst or last.The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.

-Unknown contemporary commentator, on the South Sea bubble The South Sea Company, when established in 1711, seemed an elegant solution to a number of disparate problems. It would take over Britain ' s burgeoning public debt by converting government borrowings into Company equity, its trading rights to Spain ' s American colonies could be used as a bargaining chip with the belligerent Spanish king, and the venture, if successful, promised to .ll the coffers of the Exchequer with

substantial trading pro.ts.Yet despite support from the highest levels - King George was appointed Governor of the Company in 1715 - the enterprise initially languished.The " trade monopoly " secured over the Spanish Americas was pitiful, in both senses of the word: an annual quota of 4,800 piezas de Indias (male African slaves, no defects, at least 58 inches in height), as well as one s.h.i.+p per year carrying miscellaneous commercial goods.The venture yielded no substantial pro. t and, in any case, war with Spain in 1718 effectively terminated the trading rights of the Company.

The fortunes of the South Sea Company were, however, reinvigor-ated in March 1720 when it won a bidding contest against the Bank of England to acquire more government debt in another stock - for -borrowings swap. In an effort to procure a favorable exchange rate for the conversion, promoters talked up the prospects of the Company and circulated " the most extravagant rumors " of the potential value of its trading concessions with the New World. Stock prices rocketed from 128 per share in January 1720 to just over 1,000 less than six months later. Pre.guring day traders ' chat rooms of our era, the boost-erism of Company directors was abetted by stimulant - stoked chatter in coffee houses and wildly optimistic reports in the newfangled medium of newspapers.

London was caught up in a fetish for easy money. Samuel Johnson later noted that " even poets panted after wealth " - Alexander Pope, he wrote, " ventured some of his money . . . and for a while he thought himself the lord of thousands." Although himself caught in the riptide of greed, Pope still had an eye to the deleterious effect of South Sea hysteria, which diverted the populace from the ba.n.a.l, but necessary, responsibilities of everyday life: No s.h.i.+ps unload, no Looms at Work we see, But all are swallow ' d by the d.a.m.n ' d South Sea.

Women, constrained in their dealings in real property, were par-ticularly enthusiastic partic.i.p.ants in the stock market frenzy. One lady, Sarah, d.u.c.h.ess of Marlborough, realized that prices for South Sea stock were not anch.o.r.ed to any bed of true value: Every mortal that has common sense or that knows anything of . g-ures, sees that ' tis not possible by all the arts and tricks upon earth long to carry 400,000,000 of paper credit with 15,000,000 of specie. This makes me think that this project must burst in a little while and fall to nothing.

The d.u.c.h.ess - who, her great - grandson Winston Churchill would later remark, possessed an " almost repellent common sense " - sold her shares near the market peak, pocketing the then astronomical sum of 100,000. For the following couple of months, she continued to pro.t from the mob by extending heavily secured loans to some of her more bullish peers. Ultimately, they did not share the d.u.c.h.ess ' s good fortune - prompted by the failure of a similar scheme in France, spooked by the closure of trading ports due to the Plague, and perhaps affected by a general credit squeeze, the bubble eventually burst. By December 1720 the stock had sputtered back to ground - describing an almost perfect parabola on the share price chart, South Sea paper traded at exactly the same level as at the start of the year.

As the d.u.c.h.ess of Marlborough shrewdly observed, stock exchanges can at times confect prices which veer considerably from any reasonable estimate of underlying value. Almost three centuries later, despite - and often because of - the sophistication of modern exchanges, stock markets are still p.r.o.ne to episodes in which pricing and value radically diverge. Like the d.u.c.h.ess, Maynard Keynes con-cluded by the early 1930s that, as one of his biographers put it, " the laws of arithmetic were more reliable than the winds of rumor " - far better, he decided, to ground investment decisions in the . rm foun-dation of hard a.n.a.lysis than in something as impalpable as " market sentiment."

Nullius in Verba The seekers after perpetual motion are trying to get something from nothing.

-Sir Isaac Newton (attributed) In July 1720, the British parliament pa.s.sed the " Bubble Act," which prohibited the formation of joint stock companies unless expressly authorized by Royal Charter.Although some cynics suggested that the real purpose of the legislation was to allow the South Sea Company to corner the market on investor credulity, the ostensible explanation for the Act was to curb the speculative wild.re ignited by the South Sea bubble. Exploiting the " inordinate thirst of gain that had af. icted all ranks of society " during the mad days of early 1720, other company promoters had attempted to raise money for projects of dubious merit, including a hush - hush enterprise " for carrying on an undertaking of great advantage, but n.o.body to know what it is," and another to build a wheel for perpetual motion.

Isaac Newton - the pract.i.tioner of " cold and untinctured reason " in his scienti. c endeavors - became the most famous " cully " , or vic-tim, of the South Sea hysteria. Perhaps the continued rise of South Sea stock in the summer of 1720 convinced him that the market could simply not be wrong, that Britain had indeed stumbled on a corporate El Dorado. In any case, the man who was once a dirt - poor student among the Cambridge toffs, supporting himself by scrubbing the . oors and emptying the bedpans of his more af.uent cla.s.smates, was beguiled by the vision of abundant wealth s.h.i.+mmering on the horizon. He, like so many others, became intoxicated by the " unwholesome fermenta-tion " produced by the action of animal spirits, in which " the hope of boundless wealth for the morrow made [men] heedless and extravagant for to - day."

Newton, then the President of the Royal Society, the world ' s oldest existent academy of science, failed to heed its eminently wise motto, Nullius in Verba- don ' t take anyone ' s word for it. Had he applied the same rigor to his stock speculations as he did to his scienti. c specu-lations, Newton would have realized that, just as certain fundamental laws in physics mandate that a perpetual motion machine cannot exist, so too the inexorable rise of South Sea stock could not last. Instead of following the crowd, he would have been far better served exer-cising " his unusual powers of continuous concentrated introspection," as Keynes characterized what he considered Newton ' s chief strength. Upon even a cursory a.n.a.lysis, Newton would have concluded that the prices of South Sea shares were levitating entirely as a result of the col-lective will of speculators, rather than by reference to any economic fundamentals.

The Economist and the $100 Bill A neocla.s.sical economist and his pupil are sauntering across a univer-sity green one day, discussing the .ner points of .nancial theory, when the undergraduate sights what seems to be a $100 bill skipping across the gra.s.s.The student quickens his pace to intercept the fugitive note, but the economist indulgently restrains his young charge." If it really were a $100 bill," the older man advises, " someone would have picked it up by now. "

-Market anecdote After his own stock market reverses, Keynes determined that value investing - basing the investment decision on a comparison of the likely future returns from a security against its asking price - was the best corrective to the periodic visitations of animal spirits. Value investing repudiates a fundamental tenet of the ef.cient markets hypothesis by a.s.serting that there can in fact be a sustained divergence between the quoted price of a stock and its underlying value. Value investors are fond of citing the rather arch parable of the economist and the $100 bill to parody the " strong form " of the ef.cient markets theory, which states that there are no hitherto undiscovered bargains - and, conversely, no overpriced lemons - lurking on sophisticated . nancial exchanges.

As characterized by some .nancial commentators, an ef. cient .nancial market is one in which the sheep are protected from the wolves by other wolves - that is, discerning investors will operate to trim any disparity between quoted price and true worth by bidding up apparently underpriced stocks and selling down overpriced paper. By so doing, these stock market vigilantes - the pike in the carp - pond, to borrow Keynes ' metaphor - ensure that, in theory, unsophisticated investors will not be at the mercy of the smart money.As the authors of Principles of Corporate Finance, the bible in undergraduate . nance cla.s.ses around the world, a.s.sure their readers: " In an ef.cient market you can trust prices.They impound all available information about the value of each security."

Ef.cient markets proponents will often go to great lengths to defend their theory. They may argue, for example, that the ever - ascending prices of a fervid bull market are justi.ed by a particular innovation or improvement in the economic environment - " This time it ' s different," they persuade themselves, as old valuation metrics are casually discarded. Former President Herbert Hoover, for instance, recalled the self - serving . ctions invented to justify the extravagant stock prices of the late 1920s: With the growing optimism, they gave birth to a foolish idea called the " New Economic Era." The notion spread over the whole coun-try. We were a.s.sured that we were in a new period where the old laws of economics no longer applied.

Stock market players, it is apparent, are sometimes more adept at ration-alization than rationality.

Other adherents to the orthodoxy simply proffer the circular argu-ment that prices must always be correct because they are the product of an all - knowing exchange. The comforting conceit of ef. cient markets seemingly blinds some to the common - sense observation that . nancial exchanges periodically experience spasms of irrationality, where security prices diverge considerably from any reasonable a.s.sessment of underly-ing value.The backers of the ef.cient markets hypothesis simply do not accept that on occasions there are not enough wolves to corral the sheep, and that the bleating .ock can blindly .le into a chasm.

The Weighting Game It is impossible to avoid a precipice, when one follows a road that leads nowhere else. -Jean-Baptiste Say, A TREATISE ON POLITICAL ECONOMY Ef.cient markets fundamentalists, in arguing that stock prices always incorporate all public information impacting the value of a security, succ.u.mb to an absurdly basic error.As Warren Buffett has noted: Observing correctly that the market was frequently ef. cient, [many academics and investment professionals] went on to conclude incor-rectly that it was always ef.cient.The difference between these prop-ositions is night and day.

Value investors, by de.nition, do not accept the strong form of the ef.cient markets theory. There are times when the quoted price of a security departs from its underlying value, these investors believe, and it is on these occasions that the intelligent investor seeks to exploit the mispricing that results.

Despite their skepticism about the effectiveness of the stock market in the short run, value investors generally accept that over the longer term stock markets price securities ef.ciently. As Keynes commented in a letter to a colleague," when the safety, excellence, and cheapness of a share is generally realized, its price is bound to go up." Ben Graham offers another arresting a.n.a.logy to ill.u.s.trate this tendency: . . . the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accord-ance with its speci.c qualities. Rather should we say that the mar-ket is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

In the near term, stock prices oscillate around true worth, and at times the amplitude of divergence can be signi.cant. In the longer term, however, the truth will out. As Buffett comments, " The market may ignore business success for a while, but eventually will con. rm it."

Market ef.ciency, for value investors, is therefore a question of timing - although not agreeing that .nancial exchanges are invari-ably ef.cient in the short run, they generally accept that in the long run stock markets are indeed very effective " weighing machines." As pioneering fund manager John Bogle observes, " The fact is that when the perception - interim stock prices - vastly departs from the reality - intrinsic corporate values - the gap can only be reconciled in favor of reality." This is due to a simple and indisputable mathemati-cal ident.i.ty - over time, stockholders, in aggregate, can only earn what the underlying business earns.Animal spirits lack endurance - they may de.ect prices from underlying value for a period of time, but ultimately the hard realities of earnings and dividends will determine the value of a business to its owners. Empirical evidence con.rms the effectiveness of stock markets as a weighing machine over the longer term. As one report concludes, although year - to - year stock performance is heavily in.uenced by price movements: For the seriously long - term investor, the value of a portfolio corre-sponds closely to the present value of dividends.The present value of the (eventual) capital appreciation dwindles greatly into insigni. cance.

Bargain Hunting Annual income twenty pounds, annual expenditure nineteen nine-teen and six, result happiness.Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

-Charles d.i.c.kens, DAVID COPPERFIELD Intelligent investors, then, look for stocks where the quoted price has for some reason uncoupled from any reasonable a.s.sessment of earn-ings potential.Value investing, at its simplest, is the act of getting more than is given - for a buyer of stocks, securing a stream of cash . ows whose present value is expected to exceed the purchase price, for a seller of stocks, pocketing sale proceeds which exceed any reasona-ble estimate of future dividends. As Warren Buffett summarizes, value investors: . . . search for discrepancies between the value of a business and the price of small pieces of that business in the market . . . The investors simply focus on two variables: price and value.

It is on expected earnings and dividends, therefore, that the value investor concentrates, rather than short - term price . uctuations. The quoted price of a stock is useful only as a point of reference, in deter-mining whether the market is offering substantially more or less than the estimated underlying value of the security. In explaining his invest-ment philosophy to a colleague, Keynes remarked that: My purpose is to buy securities where I am satis.ed as to a.s.sets and ultimate earning power and where the market price seems cheap in relation to these.

As Keynes emphasized, when ascertaining the underlying value of a stock, it is the company's net a.s.sets or, more often, its " ultimate earning power " that is relevant.The " intrinsic " or " fundamental " value of a stock is simply the sum of expected cash .ows from a given security, appro-priately discounted for the effects of time. Other measures commonly thought to satisfy value investment precepts - such as low price - to -earnings ratios, low price - to - book value, and a high dividend yield - are, at best, tools for identifying possibly underpriced stocks. Ultimately, however, it is the expected earning power of a stock that counts.

The value investor, therefore, adopts a " bottom - up," rather than " top - down," investment style - that is, the investor scrutinizes particu-lar stocks in an effort to determine whether there exists a discrepancy between the quoted price of the business and its a.s.sessed underlying value. Other factors - whether the stock price has trended up or down in recent times, what other stock markets are doing, whether a particu-lar sector is " hot " at the moment - are of no interest to the intelligent investor. As renowned stock - picker and .nancier Sir John Templeton counseled, the disciplined investor should " buy value, not market trends or the economic outlook." The value investor focuses on speci. c stocks rather than the broader index, and remembers always that there is no such thing as an undifferentiated " stock market " - there is only a mar-ket for individual stocks.

Eyes Forward The future ain ' t what it used to be.

-Yogi Berra (attributed) Man is a pattern - making animal, and seeks to impose order or a raison d ' e tre where it does not necessarily exist. He discerns faces in clouds and winning streaks in a coin toss, and three dots on a piece of paper will always resolve into a triangle. Likewise in the stock market, many game players believe that the trend is their friend - that what happened in the recent past is as good a guide as any as to what might happen in the future. As Keynes observed in one of his Chairman ' s speeches at a National Mutual annual meeting, " Speculative markets . . . are gov-erned . . . by fear more than by forecast, by memories of last time and not by foreknowledge of next time." Speculators generally rely on past events - price momentum and perceived market trends - as buying or selling cues.

In contrast, value investors - those who scrutinize individual stocks rather than attempting to take the temperature of the market - focus only on the likely future income from a particular security. For these indi-viduals, the investment decision is driven not by a mere expectation that prices will rise or fall over the short term, but rather by an a.s.sessment of whether stock prices appear cheap or expensive, based on an estimate of what earnings are likely to do in the long term. Intelligent investors concentrate on the business behind the stock, speculators on the stock price independent of the business. Pract.i.tioners of value investing always have intrinsic value as the bedrock of their decision - making - price merely offers a point of entry (or exit) to the investor, should it move far enough from the estimated underlying value of the security.

Virtue Rewarded I am still convinced that one is doing a fundamentally sound thing, that is to say, backing intrinsic values, enormously in excess of the market price, which at some utterly unpredictable date will in due course bring the s.h.i.+p home.

-Keynes to the Managing Director of Provincial Insurance Company,April 10, 1940 Keynes, as one of his Bloomsbury contemporaries observed, " loved a bargain." Notwithstanding his growing wealth and generous . nancial support of the arts, he watched over his personal .nances with surpris-ingly keen eyes. Keynes was not above haggling with tradesmen over a few pence, would buy large consignments of war - issue bully beef because it was only a penny a tin, and hosted dinner parties that were legendary for their frugality.Virginia Woolf noted that on one occasion Keynes served a miserly three grouse to his eleven guests - the visi-tors ' " eyes gleamed as the bones went round," she later remarked with a regulation Bloomsbury barb.The Bloomsberries, grousing about the grouse, may have extracted a few sardonic laughs at Keynes ' expense, but perhaps they missed a key point about the man. The remarkable fact was not that Keynes was a resolute bargain hunter despite his great wealth, but rather that the bulk of his riches were derived precisely because he was a bargain hunter.

In the .nal phase of his investment career, Keynes focused on iden-tifying " stunners " - those stocks which offered " intrinsic values . . . enormously in excess of market price." Although Keynes professed scant faith in the ef.ciency of .nancial exchanges at any given point in time, he did concede that, in the longer term, the stock market would rec-ognize the value inherent in a security and reward performance. The intelligent investor, therefore, focuses on the future earnings ability of a particular stock, rather than being diverted by past trends in the market as a whole. Short - term price .uctuations, the excitement generated by an in.ux of animal spirits, stock market whims and fas.h.i.+ons - all these are of absolutely no import to the discriminating investor.The only relevant factor is the disparity, if any, between price and the estimated intrinsic value of a stock.

Keynes ' value investing discipline effectively s.h.i.+elded him from the a.s.saults of animal spirits during the 1930s and 1940s. Unlike Newton, who during the South Sea imbroglio followed the crowd and neglected to .ex his mental muscles in the .eld of .nance, Keynes applied his own a.n.a.lysis rather than trying to antic.i.p.ate the market. In a letter to Richard Kahn, a former pupil and Second Bursar at King ' s, Keynes summarized his value investing philosophy as follows: It is a much safer and easier way in the long run by which to make investment pro.ts to buy 1 notes at 15 s. than to sell 1 notes at 15s. in the hope of repurchasing them at 12 s. 6d.

Or, rephrasing this maxim in decimal terms, we could say that it is pref-erable to buy one - dollar bills at seventy cents, rather than selling them at seventy cents in the hope of subsequently repurchasing the notes at . fty cents.

To return to the beauty contest a.n.a.logy in The General Theory, a value investor - after proper re. ection - will determine whom he or she thinks is the prettiest contestant, rather than trying to second - guess the second - guesses of others. The intelligent investor has faith that, eventually, the prettiest girl will indeed step up to the podium.

Chapter 9

Safety First

The Fall of the Nous of Ussher I would rather be vaguely right, than precisely wrong.

-Keynes (attributed) James Ussher was a man of many talents - Archbishop of Armagh, Primate of All Ireland, Privy Councillor, and Vice - Provost of Dublin ' s Trinity College. But perhaps his greatest gift to posterity was his detailed study on the chronology of the Bible, undertaken in the mid - seventeenth century during the last decade of his life. By adding up the genealogies of Adam and his brood, and painstakingly cross - referencing these against other cla.s.sical texts, Ussher deduced the exact date of Creation. The world, he declared, saw its .rst sunrise on Sunday, October 23, 4004 bc. Working from this absolute base, he could then calculate other key dates from Genesis - Adam and Eve, for example, were ejected from Paradise on Monday, November 10, 4004 bc, and Noah ' s Ark .nally b.u.mped into Mount Ararat on May 5, 2348 bc, a Wednesday.

Archbishop Ussher ' s ecclesiastical exact.i.tude - subsequently modi-.ed by Isaac Newton in his own quest to fathom the secrets of the

scriptures - is an object lesson in the perils of precision. Likewise, in the sphere of stock market investing, Keynes recognized that - due to unavoidable uncertainty surrounding future earnings - determining the intrinsic value of a stock was a necessarily fuzzy art. He had little time for the " brand of statistical alchemy " that many stock a.n.a.lysts brought to their calculations, in which the alleged value of a security was derived with pinpoint accuracy. Precision in stock valuation was noth-ing more than a consoling .ction, Keynes thought, perhaps designed to provide the illusion of certainty in an inherently unpredictable world.

Like Warren Buffett after him, Keynes rejected the application of a bogus precision when estimating the intrinsic value of a stock. He realized that not only does an overemphasis on quant.i.tative factors downplay non - numerical elements that may impact on the value of a stock, but - due to uncertainty - any stock valuation must of necessity be inexact, lying at best within a range of possible values.The prudent investor, therefore, incorporates a wide margin of error into any a.s.sess-ment of the relative merits of a security. Inverting the mindset of the typical speculator, value investors focus as much on not losing money as on potential gains - they are concerned with the return of capital, not just the potential return on capital. In his effort to avoid what he called " stumers " - situations " where the fall in value is due not merely to .uctuations, but to an intrinsic loss of capital " - Keynes focused on a policy of " safety . rst", of ensuring that a protective buffer exists between a stock ' s price and its perceived underlying value.

Omission Possible Life is the art of drawing suf.cient conclusions from insuf.cient premises.

-Samuel Butler, THE NOTE- BOOKS OF SAMUEL BUTLER In 1922, while in Germany to advise on currency reform, Keynes found himself seated next to Max Planck at a dinner for Berlin ' s . nan-cial and academic elite. Planck, a recent n.o.bel Prize winner for his pioneering work in quantum physics, revealed to his dinner companion that - perhaps in.uenced by a Munich professor ' s rueful observation years earlier that in the .eld of physics " almost everything is already discovered, and all that remains is to .ll a few holes " - he had at one stage considered studying economics. Ultimately, however, Planck had declined the opportunity to join the ranks of the dismal scientists - economics, he had decided, was simply too dif. cult.

What Planck meant, Keynes later explained, was that economics was an " amalgam of logic and intuition," incapable of distillation into the .inty certainties of the physical sciences, and it was this lack of preci-sion that made it " overwhelmingly dif. cult " for a man of Planck ' s rig-orous and deductive disposition. Although Keynes ' response to Planck ' s observation was not recorded, he no doubt would have congratulated the esteemed professor on his perspicacity. Keynes believed that, in a misguided effort to mimic the theoretical rigor of the physical sciences, cla.s.sical economics clung too tightly to a " specious precision," at the expense of " concealed factors " that are not capable of quanti. cation.

Friedrich von Hayek - Keynes ' philosophical antipode in most other areas - shared these reservations. In his n.o.bel Prize lecture, he noted that " in the study of such complex phenomena as the market . . . [many factors] will hardly ever be fully known or measurable." Cla.s.sical economists laboring under a " scientistic " att.i.tude, Hayek observed, sim-ply disregard those factors which " cannot be con.rmed by quant.i.tative evidence " and " they thereupon happily proceed on the .ction that the factors which they can measure are the only ones that are relevant." Keynes similarly deplored the " Ricardian vice " which he believed pervaded cla.s.sical economic thought - the crystallization of all inter-relations.h.i.+ps, all activities into mathematical formulas, and the dismissal of qualitative elements as unworthy of a.n.a.lysis." When statistics do not seem to make sense," he once remarked," I .nd it is generally wiser to prefer sense to statistics! "

Origins of the Specious There are three kinds of lies: lies, d.a.m.ned lies and statistics.

-Mark Twain, THE AUTOBIOGRAPHY OF MARK TWAIN Despite the fact that the only certainty about future returns from a security is their very uncertainty, a similar defect af.icts the stock market - a.n.a.lysts solemnly apply rigorous quant.i.tative techniques to derive a valuation, down to the last cent, for a particular stock. Berks.h.i.+re Hathaway ' s Charlie Munger has labeled this bias toward quanti.cation, at the expense of qualitative factors, as the " man with a hammer " syndrome - " To the man with only a hammer," he observes, " every problem looks like a nail." Echoing Hayek ' s criticisms, Munger notes that: . . . practically everybody (1) overweighs the stuff that can be num-bered, because it yields to the statistical techniques they ' re taught in academia, and (2) doesn ' t mix in the hard - to - measure stuff that may be more important.

It appears that human psychology demands this spurious precision in an effort to mask the uncertainty inherent in any investment deci-sion. As Fred Schwed observed in Where Are the Customers ' Yachts?, his cla.s.sic account of Wall Street ' s foibles: It seems that the immature mind has a regrettable tendency to believe, as actually true, that which it only hopes to be true. In this case, the notion that the .nancial future is not predictable is just too unpleas-ant to be given any room at all in the Wall Streeter ' s consciousness.

Keynes agreed that this sham exact.i.tude was the stock market ' s equiva-lent of whistling in the dark, noting that " peace and comfort of mind require that we should hide from ourselves how little we foresee."

Elaborate quant.i.tative a.n.a.lysis may also be an attempt to clothe mere hunches in a cloak of intellectual respectability. The economist Robert s.h.i.+ller, author of the book Irrational Exuberance, remarks that sometimes: . . . inst.i.tutional investors do not feel that they have the authority to make trades in accordance with their own best judgments, which are often intuitive, that they must have reasons for what they do, reasons that could be justi. ed to a committee.

Complex and comprehensive spreadsheets - calculating cash . ows, risk - adjusting returns, deriving stock valuations with unimpeachable cert.i.tude - are often nothing more than an elaborate alibi, designed to confer a bogus authority to inherently uncertain subject matter.

Girl in the Gorilla Suit Not everything that counts can be counted, and not everything that can be counted counts.

-Sign hung in Albert Einstein ' s Princeton study The psychology experiment sometimes known as " the girl in the gorilla suit " ill.u.s.trates how focusing too tightly on some factors can distort the bigger picture. In this experiment, subjects were shown a short video of two teams pa.s.sing a basketball among themselves, and were asked to count the number of pa.s.ses made by one of the teams. While team members are .ring basketb.a.l.l.s at each other, a woman in a gorilla suit lopes on to the court, stops, faces the camera and pounds her chest before moving off - screen. Around half of the partic.i.p.ants in the exercise claimed not to have seen the apish apparition - they were simply too preoccupied with diligently counting the number of pa.s.ses made by " their " team.

In a similar way, an excessive focus on quant.i.tative data can warp stock valuations.As Ben Graham commented: . . . the combination of precise formulas with highly imprecise a.s.sumptions can be used to establish, or rather to justify, practically any value one wishes . . . in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom.

Graham ' s own solution to this problem was not to reduce his reliance on quant.i.tative factors, but rather to impose a more onerous test on potential acquisitions. In his book The Intelligent Investor, Graham sug-gested " readers limit themselves to issues selling not far above their tangible - a.s.set value." Such a high hurdle would, he thought, ensure that investors secured a suf. cient " margin of safety " in their stock purchases.

Fingers and Toes Investing Charlie Munger: We have such a " .ngers and toes " style around here.Warren often talks about these discounted cash .ows, but I ' ve never seen him do one . . .

Warren Buffett: That ' s true. It ' s sort of automatic. If you have to actually do it with pencil and paper, it ' s too close to think about. It ought to just kind of scream at you that you ' ve got this huge margin of safety.

-Berks.h.i.+re Hathaway annual meeting, 1996 In determining whether a stock displayed the necessary margin of safety - a suf.ciently wide gap between a.s.sessed intrinsic value and quoted price - Ben Graham exhibited his own particular variant of the " man with a hammer " syndrome. His valuation approach was essentially a static one, concentrating mainly on the value of a company ' s physical a.s.sets.This technique might have been appropriate in the wake of the Great Depression - where stocks were sometimes of.oaded at . re- sale prices and physical a.s.sets const.i.tuted the bulk of a . rm' s worth - but it is of limited practical value in today ' s world, where it is estimated that almost three - quarters of the market value of companies in the Standard & Poor ' s 500 comprises intangible a.s.sets, such as brand names, patents and " human capital."

Keynes, like Warren Buffett after him, practiced a more dynamic valuation methodology - one focused on projected earnings accruing to a particular . rm.The notional tool used in this type of a.n.a.lysis is the " dividend discount model." This model states that the intrinsic value of a given security is determined by the stream of its prospective dividend payments over time, discounted back to a present value.Warren Buffett highlighted the tasks required of an investor using this technique: If you buy a bond, you know exactly what ' s going to happen, a.s.suming it ' s a good bond . . . If it says 9 percent, you know what the coupons are going to be for maybe thirty years . . . Now, when you buy a business, you ' re buying something with coupons on it, too, except, the only problem is, they don ' t print the amount.And it ' s my job to print in the amount on the coupon.

Unlike government or corporate bonds - which carry a known coupon and a predetermined maturity date - the expected income . ow from a security cannot be determined with any degree of precision. Instead, the investor must refer to qualitative factors when determin-ing the value of a stock.Warren Buffett provides an everyday a.n.a.logy to describe the derivation of intrinsic value: It ' s exactly what I would do if I were going to buy a Ford dealers.h.i.+p in Omaha - only with a few more zeros. If I were going to try and buy that business - let ' s say I weren ' t going to manage it - I ' d try to .gure out what sort of economics are attached to it:What ' s the com-pet.i.tion like? What can the return on equity likely be over time? Is this the guy to run it? Is he going to be straight with me? It ' s the same thing with a public company.The only difference is that the numbers are bigger and you buy them in little pieces.

Ascertaining the intrinsic value of a stock is a necessarily inexact art - as Buffett observes, the underlying or fundamental value of a stock is " a number that is impossible to pinpoint but essential to estimate."

The Half - Empty Gla.s.s Fish see the bait, but not the hook; men see the pro.t, but not the peril.

-Chinese proverb Intrinsic value, then, is a nebulous measure, existing at best within a range of possibilities. The importance of qualitative elements means that calculations of intrinsic value, properly done, cannot move beyond a fairly basic level of a.n.a.lysis - as Ben Graham observed, he had never " seen dependable calculations made about common - stock values . . . that went beyond simple arithmetic or the most elementary algebra." The bene.t of intrinsic value calculations lies as much in providing a checklist to ensure that the investor has turned his or her mind to all major factors potentially impacting the price of a security as in ascer-taining an actual range of values.As Warren Buffett explains: Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless a.s.serted, " I know it when I see it," so also can investors - in an inexact but useful way - " see " the risks inherent in certain investments without reference to complex equations or price histories.

Compensating for this necessary imprecision is the concept of a margin of safety- a buffer, in Ben Graham ' s words, " for absorbing the effect of miscalculations or worse than average luck." Value investors, accepting the inexactness of intrinsic value measures, seek to iden-tify those stand - out stocks that appear to display an undeniably large gap between underlying worth and quoted price. Although these " ultra favorites " or " stunners," as Keynes called them, may not display a sharply de.ned intrinsic value, a suf.cient margin of safety should nevertheless be evident. Ben Graham and his co - author David Dodd explained the concept in their book Security a.n.a.lysis: To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.

Value investing is, in essence, a " gla.s.s half - empty " rather than " gla.s.s half - full " approach - it focuses on downside risks rather than those on the upside. By selecting only those stocks that appear to be priced at a substantial discount to intrinsic worth, the investor ensures that there is a " . oor " of underlying value that should support pricing over the longer term. The speculator, in contrast, is princ.i.p.ally concerned not with the underlying earnings of a business but rather whether the stock can be of.oaded at a higher price.As Fred Schwed observed: Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to pre vent a lot of money from becoming a little.

Keynes noted that for those seized by animal spirits, " the thought of ultimate loss . . . is put aside as a healthy man puts aside the expectation of death." Value investors, on the other hand, focus heavily on downside risks before investing, by seeking to ensure a suf.cient margin of safety exists in respect of any potential purchase.

Pick - a - Number Having a past actually counted against a company, for a past was a record and a record was a sign of a company ' s limitations . . .You had to show that you were the company not of the present but of the future.

-Michael Lewis on dot - coms, THE NEW NEW THING Reviewing a journal article on statistical methods, Keynes recalled the mythical account of the seventy scholars asked to translate the Old Testament into Greek for inclusion in the Library of Alexandria: It will be remembered that the seventy translators . . . were shut up in seventy separate rooms with the Hebrew text and brought out with them, when they emerged, seventy identical translations.Would the same miracle be vouchsafed if seventy [a.n.a.lysts] were shut up with the same statistical material?

Keynes had very little faith in the ability of purely quant.i.tative methods to come up with meaningful estimates of intrinsic worth. Quoting the nineteenth - century journalist Walter Bagehot, he agreed that " there is no place where the calculations are so . ne, or where they are employed on data so impalpable and so little ' immersed in matter ' " as on the stock exchange. Consequently, there exists a very frail foundation for the calculation of a stock ' s underlying value, and there may be widely divergent opinions on the worth of a security.