I remember looking at Eastman Kodak a number of times over the last decade. Often a few metrics would look cheap, but when I would look at the bevy of factors in the financials and consider the effects of technology, I could never get myself to be a buyer. To me, it seemed to be the ultimate value trap — a modern buggy whip company.
That’s why the behavior of Bill Miller, a so-called value investor, was so surprising to me. He had a saying, “lowest average cost wins,” but that implies that the stock will rise at some point. For stocks that keep falling, the average cost does not matter. And lest I seem to be boasting, I made the same mistake on Deerfield Capital.
But he did the same thing on Freddie Mac, though that was more dramatic.
The core idea of value investing is NOT “buy cheap,” (lowest average cost) but margin of safety. My greatest mistakes in investing came from not seeking enough margin of safety. Same for Bill Miller, though the effect on his track record was far greater.
Miller looks to me like he had some skill (beating the S&P500 for 10 years), but more or less was just lucky in terms of his starting period – meaning that he got started right before an enormous bull market, which favors his strategy.
Miller seems unable to see huge strategic risk in his investment – he had that in Freddie, and he had that in Kodak.
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Miller is a very smart and talented investor, but he was neither as great as his 10+ year run seemed to indicate nor as bad as his subsequent few years alternately indicated. He definitely is a value-oriented investor, but his definition of value is very different than most. He is neither a “margin of safety” investor nor simply a “cheap” investor. Yes, he buys some very cheap stocks, but he also buys relatively expensive stocks that he thinks warrant an even higher price.
He essentially got “lucky” (I’m not a big believer in the common usage of the word, but it’s somewhat appropriate here) investing during a period where a) buying the dips was the best strategy you could take and b) commodity stocks never took significant leadership. He has never been an energy/commodity fan, and that those areas never took off during his long winning streak was of great benefit to him. This market environment will be infinitely harder for him to consistently add value. I, for one, wouldn’t touch his fund with a 100-ft pole.
This is why I hate the mindset you have to have in investing. This is both a quantitative and qualitative exercise. Its very tempting to buy cheap beachfront house when the Tsunami is still just people talking.
I am not in the profession related to investments, so this question maybe naive. I read the freddie piece linked to this blog entry for the first time today and I don’t understand why people would even try to estimate how much loss Fannie/Freddie would have to writedown before its profitable. Is there a reason you have to invest in Fannie and Freddie since this calculation would be so hard? Do you only make money if you are able to closely estimate these things that looks impossible to me? Maybe this is just hindsight 20/20 thing given the blog entry is 2008.
No reason why you would have to invest in F&F, but they looked really cheap relative to book and past earnings. Many like Miller and Dreman did not do the requisite homework.
It is akin to paying attention to the symptoms of value as opposed to the underlying condition of value.
Attractive ratios, while often an indicator that there may be value buried somewhere down below, are not themselves the definition of value.
When I started thinking of stocks as businesses, margin of safety started to click. Now I focus on the drivers of the underlying business and ask how protected those drivers are (and with them, sales, margins, required capital etc.). How much do I have to pay for this level of protection, and most importantly, how much room is there for me to be wrong and still not lose money?
It took me a long time to focus on margin of safety as opposed to “statistically cheap” stocks. But “statistically cheap” sure provides a lot of intellectual cover when one is pitching a stock to superiors.
Well said.