When I Met The Legends Of Investing

by: Vishal Khandelwal

"I have noticed one thing…" I told my wife, "…that whenever we are on a holiday, the stock markets take a nosedive."

"Oh, you and your stock market!" she replied with expected frustration. "You always promise at the start of the holidays that you won't look at stocks, but then…"

"Yes dear, you know I don't look at daily stock prices while on a holiday or even otherwise, but the way stock prices are moving these days, I can't help but take notice."

"Forget it! Let me sleep now for we have a long day tomorrow touring the entire city."

"Yeah, even I need a good night's sleep," I said, "…and possibly continue my dream of meeting the legends of investing who have guided me well in the past.

"Amidst this excessive stock market volatility, I surely need to get my thoughts re-aligned."

And the dream follows…

Me: Mr. Buffett, in the last dream, you explained me the three kinds of businesses - the great, the good and the gruesome.

Now, as I see around, I see extreme volatility in stocks of all these three kinds of businesses! I am not sure how an investor must react to such a volatile environment.

Warren Buffett: You mention volatility - it doesn't make any difference to us whether the volatility of the stock market is a half a percentage of a point a day, or a quarter percent a day, or five percent a day.

In fact, we'd probably make a lot more money if volatility was higher because it would create more mistakes in the market.

Me: You can make more money when volatility is higher? How?

Buffett: You see, volatility is a huge plus to the real investor. Ben Graham used the example of Mr. Market.

Ben said that just imagine that when you bought a stock you in effect bought into a business where you have this obliging partner who comes around every day and offers you a price at which he'll either buy or sell and that price is identical.

No one ever gets that in a private business, where daily you get a buy-sell offer by a party.

But you get that in the stock market, and that's a huge advantage. And it's a bigger advantage if this partner of yours is a heavy-drinking manic depressive. The crazier he is, the more money you're going to make.

So, as an investor, you love volatility. Not if you're on margin, but if you're an investor you're not on margin, and if you're an investor you love to get these wild swings because it means more things are going to get mispriced.

Me: But so much volatility? Isn't that a huge risk to being an investor these days?

Buffett: Actually, volatility in recent years has dampened from what it used to be. It looks bigger because people think in terms of Dow points, but volatility was much higher many years ago than it is now.

The amplitude of the swings used to be really wild and that gave you more opportunity.

Charlie, you want to touch up on the risk from stock price volatility?

Charlie Munger: Well it came to be that corporate finance departments at universities developed the notion of risk-adjusted returns. My best advice to you would be to totally ignore this development.

Risk had a very good colloquial meaning, meaning a substantial chance that something could go horribly wrong, and the finance professors sort of got volatility mixed up with a bunch of foolish mathematics and to me it's less rational than what we do. And I don't think we're going to change.

Me: So are you saying that volatility in stock price doesn't equals risk?

Munger: Finance departments believe that volatility equals risk. They want to measure risk, and they don't know how to do it, basically. So they said volatility measures risk.

I've often used the example of the Washington Post's stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million.

Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million.

That's something I've thought about ever since they told me that 25 years ago and I still haven't figured it out.

Me: Ha ha! You're being humble!

Munger: One key aspect to risk is how long you expect to hold an investment, i.e., stock in Coca Cola might be very risky if bought for a day trade or to hold for only a week. But, over a 5- or 10-year period it probably has almost no risk at all.

Buffett: In fact, volatility often creates great opportunity.

Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions.

Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times.

Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

Me: I want to clarify again, Mr. Buffett and Mr. Munger. You are saying that stock prices moving up and down is not risk?

I find this unbelievable…especially when everyone around me seems so worried about stock prices being so volatile these days!

Buffett: We regard using a stock's volatility as a measure of risk is nuts.

Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.

Some great businesses have very volatile returns and some terrible businesses can have steady results.

Munger: How can professors spread this? I've been waiting for this craziness to end for decades. It's been dented, but it's still out there.

If someone starts talking to you about beta, zip up your pocketbook.

Me: Okay, I take your point that stock prices moving with such great volatility is not risk. But how does one value stocks in such uncertain times?

Buffett: The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush.

Investing is about laying out a bird now to get two or more out of the bush.

The keys are to only look at the bushes you like and identify how long it will take to get them out.

When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta.

Me: So an investor must not care about volatility at all, right?

Buffett: I don't really care about volatility. Stock price is not that important to me. It just gives you the opportunity to buy at a great price.

I don't care if they close the NYSE, or for that matter your BSE, for 5 years. I care more about the business than I do about events.

Seth Klarman enters the scene.

Buffett: Hey Seth, what a great timing for your entry. You have written that masterpiece called "The Value of Not Being Sure".

Can you share with Vishal your take on investing during uncertain times like these, and how such times actually provide great opportunities for long-term investors?

Seth Klarman: Sure Warren!

Vishal, time horizons have shortened even more than usual, to the point where the market's 4:00 p.m. close seems to many like a long-term commitment.

To maintain a truly long-term view, investors must be willing to experience significant short-term losses; without the possibility of near-term pain, there can be no long-term gain.

Me: Yeah Mr. Klarman, I can vouch for that! I have been a long-term investor in some stocks, and a "forced" long-term investor in many! It's really painful to see your stocks in the red!

Klarman: Well, the ability to remain an investor (and not become a day-trader or a bystander) confers an almost unprecedented advantage in this environment.

The investor's problem is that this perspective will seem a curse rather than a blessing until the selloff ends and some semblance of stability is restored.

As Benjamin Graham and David Dodd taught us, financial markets are manic and best thought of as an erratic counterparty with whom to transact, rather than as an arbiter of the accuracy of one's investment judgments.

There are days when the market will overpay for what you own, and other days when it will offer you securities at a great discount from underlying value.

Me: Oh okay. You are talking about Mr. Market, right? Buffett was talking about him just a few moments back.

Klarman: Yes! If you look to Mr. Market for advice, or if you imbue him with wisdom, you are destined to fail.

But if you look to Mr. Market for opportunity, if you attempt to take advantage of the emotional extremes, then you are very likely to succeed over time.

If you see stocks as blips on a ticker tape, you will be led astray. But if you regard stocks as fractional interests in businesses, you will maintain proper perspective.

This necessary clarity of thought is particularly important in times of extreme market fluctuations.

Me: Times like these, right?

Klarman: Yes!

Me: But tell me one thing - and this question worries me day and night - what investors must do to tide over such uncertain times?

I find it really difficult to foresee a great future for my stocks, given that this uncertainty seems to be prolonging till eternity!

Klarman: Especially in today's difficult environment, you as an investor must keep firmly in mind that the only things you really can control are your investment philosophy and investment process.

Me: Yeah, even Mr. Buffett and Mr. Munger have stressed on the importance of process in investing.

Klarman: Yes, controlling your process is absolutely crucial to long-term investment success in any market environment.

A leading market strategist and a dear friend, James Montier, has pointed out several times in the past that when athletes were asked what went through their minds just before competing in Olympics, the consistent response was a focus on process, not outcome.

The same ought to be true for investors.

Success virtually requires that an investment process be in place that enables intellectual honesty, rigor, creativity, and integrity.

Me: What else apart from the process?

Klarman: Resolve. Successful investing requires resolve.

When taking a contrary approach, one has to be able to stand one's ground, be unwavering when others vacillate, and take advantage of others' fear and panic to pick up bargains.

But successful investing also requires flexibility and open-mindedness.

Investments are typically a buy at one price, a hold at a higher price, and a sale at a still higher price.

You can never be sure if the economy will grow or shrink, whether the markets will rise or sink, or whether a particular investment will meet your expectations.

Amidst such uncertainty, people who are too resolute are hell-bent on destruction.

Successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong.

What say Mr. Buffett?

Buffett: The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.


Munger: I have nothing to add.