Sunday, June 29, 2008

Bicycling and Value Investing

I decided to go for a bike ride out in the country this afternoon since I knew that I would be getting an extra dose of calories during dinner at my mother in-laws later this evening. I set off enthusiastically after doing the requisite research with Google maps to ensure that my planned route actually had roads to travel on. As I turned the pedals on my mountain bike I kept my brain active by establishing parallels between two of my favourite activities, bicycle riding and value-investing.

Cycling away from the city towards the country had the pleasant effect of taking me away from automobile traffic. This distinctly contrarian action allowed me to take more than my fair share of the road, as there were absolutely no cars following me once I had gone around 5 km out of the city limits. Similar to my observation of the benefits of low traffic on country roads, if you invest in sound companies that are not popular or are currently out of favor, you have an opportunity to obtain more shares for your dollars then when a stock is popular. Combined with an informed understanding of a company’s intrinsic value, the industry it competes in and any competitive advantages that it might possess, I believe you can obtain excellent investing results as other great value investors have done before us.

I turned left on Ranger Rd. and shortly thereafter watched in horror as the largest Rottweiler I have ever seen tried to intercept my course with an extremely aggressive sprint in a near-perfect diagonal run that would have bested any in this year’s Euro Cup. The loose “beast” must have picked up early sounds (or scent) of my approach.

My recent MBA degree from the Richard Ivey School of Business was put to quick work. Operationally I should have the advantage on a bike as long as I maxed out on acceleration immediately. Financially it made sense to speed up since the time value of money dictated that I should get home asap to start on another company intrinsic valuation. Economically I was on solid ground as Adam Smith would advocate self-preservation and the invisible hand would take care of the rest. Strategy was a no-brainer, I needed to implement this plan or I was dead. Almost instinctively I put everything into accelerating the bike and just barely avoided the savage onrush. Even as I was cycling for dear life ahead of the massive dog, it relentlessly pursued me, testing my reserves and only giving in when I had a sizable distance opened up between us.

My parallel to investing became obvious. I needed enough reserve energy to survive this encounter and companies need enough cash flow to survive unexpected events. During a speech by Walter Schloss, I learned that this great value investor avoids companies with “high” leverage because he doesn't want to take the risk that they will be unable to have enough cash to weather unforeseen “business storms”. This is an important lesson for value investors and Walter’s impressive track record is a good reason to take heed of his advice.

George Soros came to mind shortly after a second attack on my life was launched by a German Shepherd. Luckily on this day I had enough energy reserves to survive the test. George’s famous “sore back” comes on when the flaw(s) in his investments are not known to him. My bike-ride flaw was travelling on unknown roads without a stun gun. When you invest in companies you should think critically of the things that can go wrong in the industry, the company, with customers, with management and so on. It is only after careful consideration of the facts that an overall assessment of the investment appeal can be made. This is why Benjamin Graham’s “margin of safety” is such a valuable tool to apply to the intrinsic value estimation of a company. After diligently calculating the intrinsic value of a business, methodically apply a discount factor to this value to reach an entry price for the company’s stock. The margin of safety gives you some extra assurance that you are getting a good purchase price for the stock. After all, as with cycling, you can never be certain of precisely all the events that will transpire and affect a business.

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