Saturday, February 27, 2016

Adventures In The Bargain Bin

I was at my local grocery store last week, and noticed that salmon fillets were 50% off. I stood in front of the display for a good two minutes, racked with indecision. I like salmon. It's usually more expensive than other meat, and it's rare to see it on sale. I vaguely recalled a Buffett quote about being happy to buy merchandise when it went on sale. And yet, I just couldn't bring myself to buy it. The fact that salmon is rarely on sale suggested to me it might not have been the freshest fish. Also, that store doesn't have the best reputation for selling the freshest meat & produce. And so I walked away.

I've written before that it's one thing to be a value investor, and another thing to be a cheapskate. But the salmon episode got me thinking: why couldn't I pull the trigger on what appeared to be something on sale? Two issues seemed key:

1) I couldn't be sure of the fish's quality. I looked up the Buffett quote when I got home: "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down." The word "quality" is very important in that quote. The salmon price mark-down was in fact signalling something about the quality of the merchandise, and I didn't like the signal I was getting.

2) The consequences of being wrong could be deeply unpleasant. If you buy a cheap pair of socks and discover the elastic is already worn, the worst that happens is that you've wasted a few dollars and have to toss the socks in the trash. Not true of food, though: if the salmon had been less than fresh, it probably wouldn't have been life-threatening, but could easily have made me miserable for a day or two!

My adventures in the bargain bin have some clear implications for investing. Value-oriented investors are often drawn to stocks that have been beaten up, but it requires some genuine judgment to assess if price declines are warranted. Similarly, they may shy away from companies trading at lofty multiples, believing that valuations are excessive, even if the underlying company has excellent fundamentals. As with fish, this judgment depends on accurately evaluating the quality of the stocks and the consequences of being wrong.

Assessing quality is aided by the following:

a) Deep fundamental research. This should be a prerequisite, of course, but without this kind of work, it becomes far too tempting to use price as a signal of quality.

b) Stress testing/scenario analysis to understand if quality is genuine. I'm reminded of a great Ben Graham quote: "The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety." I suspect there are many investors in the natural resources complex who have become painfully aware of the truth of Graham's words over the past 12-18 months.

c) Long ownership or familiarity with a company/industry. Most people value a long-term investment horizon because when done right, it is easier to implement and more profitable than a trading strategy. As Phil Fisher wrote, "Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." This long-term ownership, however, serves another important purpose. Over time, the analyst has the opportunity to observe the company through different economic conditions, and develops an understanding of its economic sensitivity.  Following a business for a long time reduces the risk that one will mistake cyclical earnings for true earnings power.

Finally, it's worth noting that one's willingness to take a risk should depend on the severity of a negative outcome. Socks with loose elastic are harmless, rotten fish less so. As Sanjay Bakshi points out in a wonderful speech, the eventual consequences of risk-seeking or risk-blind behaviour can be dire in many aspects of life. This is certainly true for one's long-term financial well-being. Sometimes, when something smells fishy, it's best to just walk away.

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