A Different Approach to Investment

1
A Different Approach to Investment

• Luncheon Talk and Roundtable Discussion
• Montreal Economic Institute
• May 19, 2005
• By Chris Leithner

2
A Thought Experiment

•  How much are you willing to pay today for the
  right to receive 100 in exactly one year?
• Assume that the receipt of the 100 is absolutely
  guaranteed the probability that you will
  receive it, in other words, is exactly 100.

3
Benjamin Graham An Overview

• Benjamin Graham (1894-1976) was both an investor
  and an adjunct academic.
• He wrote Security Analysis (1934 and subsequent
  editions) and The Intelligent Investor (1949).
• According to Graham, investment is most
  successful when it is most businesslike. An
  investment operation is one that, upon thorough
  analysis, promises safety of principal and a
  satisfactory return. Operations not meeting these
  requirements are speculative.
• Day to day, week to week, etc., the operations of
  a business are more stable than the assessments
  of its value.

4
Benjamin Graham Four More Points

• Graham maintained that price and value are
  distinct things price is what is paid and value
  is what is received
• observed that over time price and value gravitate
  towards one another but that at any given point
  in time they may diverge (sometimes by a wide
  margin and for an inconvenient length of time)
• and lamented that most people rarely recognise
  and more than a few wilfully ignore the
  fundamental distinction between value and price.
• Value investors thus reject the mainstream view
  that the price and value of a security
  necessarily coincide at all times.

5
The Austrian School An Overview

• It is not a field of economics rather, it is an
  alternative way of looking at production and
  exchange in the market.
• Its founding dates from the publication of Carl
  Mengers Principles of Economics (1871). This
  book, which grounded economics in deductive laws
  of human action, revolutionised economists
  understanding of valuing and pricing resources
  (and, by implication, assets and securities).
• Austrians see entrepreneurship as critical in
  economic development, private property as
  essential to an efficient use of resources, and
  government intervention in the market as always
  and everywhere destructive.

6
The Austrian Schools Insights for Investors

• Buyers and sellers in the market have different
  values, preferences, needs and desires, time
  horizons and goals.
• Markets do not do anything only individuals
  act. It is not possible to collapse the
  complexity of actions in the market into
  aggregates (such as stock market indices, CPI and
  other measures).
• Capital is subjective and the capital stock is
  heterogeneous.
• Competition is a process whereby new and better
  ways to organise production are discovered.

7
A New Approach Based Upon Old Principles

• Buy sound assets whose expected rate of return
  over the medium term (5 years or more) is
  significantly greater than your natural rate of
  interest.
• If you cannot find such assets, place funds into
  secure, liquid and short-term securities (e.g.,
  90-day commercial paper).
• When you do find such an asset, buy enough such
  that it comprises 5-10 of your portfolio.
• Sell assets whose expected rate of return over
  the medium term (5 years or more) has become
  significantly less than your natural rate of
  interest.

8
A New Approach (Continued)

1. Seek cautious business entrepreneurs and avoid
   political entrepreneurs.
2. When looking for investment opportunities, stand
   apart from the crowd.
3. Avoid the crowds mainstream economic follies.

9
How Does This Approach Differ from the Mainstream?

• Distinction Between Price and Value
• Conception of Risk
• Scepticism About Mathematical Modelling
• The Future Is Largely But Not Radically Uncertain
• Value Investors as Austrian Entrepreneurs

10
Conclusion Austrians Relevance to Value
Investors

1. It helps to inoculate against absurdity. The next
   time somebody tells you with a straight face that
   all investors have the same information,
   expectations and time horizon that markets are
   very liquid, making transaction costs so small
   that they can be ignored and that value and
   price are synonyms, the sane response is to
   laugh.
2. It helps to avoid over-optimism and unwarranted
   pessimism, i.e., bumping into things in the dark.
   
3. For capitalists, businessmen and investors,
   Austrian School economics is neither a necessary
   nor a sufficient condition of reasonable results
   but it certainly helps