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Monday, 13 October 2008

Now's the time to make low risk, high return investments

Investors are ignoring the intrinsic value of a company, which is a longer-term variable. By Tan Teng Boo


LOW risks, high returns?

Benjamin Graham estimated that only one out of every 100 investors who were invested in the stock market in 1925 survived the 1929-1932 stock market crash.

While this shows the severity of the crash, what interests us most is the one investor who survived. Benjamin Graham, the father of fundamental analysis and the teacher of billionaire Warren Buffett, lost heavily in the 1930 Great Depression. However, due to his value investing style, he survived. He probably is the one in a hundred. What made him succeed when so many others failed?

Today, we are bombarded with plenty of grave news and scary developments from the US and Europe that send chills down our spines. We are constantly told that the US-generated financial crisis happens only once in a lifetime. This article is not about how serious the financial crisis is or will be or what should or could have been done. This article is more forward-looking and hopefully more constructive.

Modern finance theory tells us that to earn high returns, we need to take high risks. Unfortunately, the end result of such an approach is inevitably tragic as often, the high risks taken produce no returns or, worse, negative returns.

As a fund manager, our approach is diametrically opposite, that is, low risks, high returns. While this may sound oxymoronic, a closer look will show that it makes plenty of sense, especially in the current environment where so many think that the world is coming to an end.

In the current circumstances, petrified investors watch in horror the almost daily plunge in share prices. There seems to be no end to the carnage. What is forgotten by or unknown to investors is that it is precisely this type of environment that one can make low risk, high return investments. What do we mean?

Amid all the fears and worries, it is so easy for investors to know everything about price and nothing about value. This overlooked truism comes from Oscar Wilde. While he is certainly not a famous investor, what he says aptly describes the paralysis that is gripping the financial markets. Many investors are focused on what will happen in the next few months. In so doing, investors ignore the intrinsic value of a company, which is a longer-term variable.

Plunges in the share price do not affect the intrinsic value of a company. As the share price falls below the intrinsic value, these market plunges instead create investing opportunities. Central to value investing is the concept of a margin of safety and central to having this margin is to buy companies at prices which are below their long-term intrinsic values.

Investors should not worry about calculating the exact values; they are just approximations. As Benjamin Graham puts it correctly, 'It is quite possible to decide by inspection that ... a man is heavier than he should be without knowing his exact weight.'

What is critically important is for investors to have a margin of safety. The current fear and panic give investors precisely that. It is precisely because share prices have dropped so sharply while the longer-term intrinsic values of many companies have not, that one can have this safety margin. To be able to sleep soundly, short-selling and derivatives are to be avoided. That lowers risks without compromising our returns.

If investors adopt this conservative approach, then, the current atmosphere of fears and worries can actually be exciting. Instead of being frozen in fear that the world is near its end, we can guarantee that the bear market will end. Do not aim for the precise market bottom. Just make sure that when you invest, you have a sufficient margin of safety, then tell yourself that you are seeing an investing opportunity that happens only once in a lifetime. Okay, we may be exaggerating but you get the drift.

The writer is managing director of a fund management firm, Capital Dynamics (S) Pte Ltd.

1 comment:

Eric said...

OK, Fine..... but what is the 'intrinsic value' of financial stocks today? A banker very recently said to me "by our benchmark you are underexposed to financial stocks" (it was then down to 7%). What a laugh! It will probably be down to 0% by the end of this week, and my cash position 50% without having sold any stocks.
Time I re-read Benjamin Graham.

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