You have to look for a margin of safety in every stock you
buy. If you can't find a margin of safety - you have to hold
Two people who read
sent me these emails]:
My question is what strategy should an investor adopt when
the market is rising (generally good stocks are not available at
reasonable prices in such circumstances)? Should an investor just
wait on the sidelines when the market continues to rise?
And the second email:
In general, how do you approach the macro investor problem:
When markets are down, value investors pile in, but when markets
are up, what should value investors do? Underperform?
That's what I'm doing now. I have 75% of my portfolio in cash.
And I am underperforming. I am up 5% in 2012. The S&P 500 is
up 11%. It is no fun making 5% a year. And it is no fun being
beat by the S&P 500.
But when you keep 75% of your assets in cash - you know that has
to happen. I would love to be 100% invested. I would always love
to be 100% invested. But when I can't find stocks I like with a
margin of safety - I stay in cash.
It's odd for me to have 75% in cash. I can't think of any time in
recent years where I kept more than 50% of my portfolio in cash
for more than a month or so. It just never happens. But it's
happening now. It's been happening for most of 2012.
We all have rules. We all have habits. We all have ways we like
to invest. Most investors diversify more than I do. I have low
standards when it comes to diversification. I have high standards
when it comes to stock selection.
Like I said in a recent article - my required rate of return is
10%. If I don't think I can make 10% a year in a stock - I don't
buy that stock.
So I have a rate of return hurdle. I also have a value hurdle. I
need to know the stock I am buying is - conservatively calculated
- worth more than what I am paying. I need clear and convincing
evidence of that.
I also have a safety hurdle. We'll call it a comfort hurdle. I
need to be comfortable with the industry, the organization, the
management, the balance sheet, etc. There needs to be a low risk
of catastrophic loss.
I don't like looking at stocks where I think there is a real
chance of losing 50% of my investment.
I don't own banks. Over the last few years - there were many
cheap banks. There still are some. Many of them have a real risk
of catastrophic loss. You could lose 50% of your money if the
world goes against you.
That is not true in
Kimberly Clark (
. That is not true in
Waste Management (
. That is not true in
. Or in
Those are companies in industries with solid demand. They are
businesses with solid competitive positions. If you know they are
cheap - and you know they can make you 10% a year - those are
stocks you can feel safe buying.
So when I say I'm not finding stocks to buy - I am saying I'm not
finding stocks that check all 3 boxes at once. They need to be
worth more than they are trading for. They need to be safe. And
they need to offer a return of 10% a year.
There are some stocks I know are safe. A good example is
. That is a safe stock. Demand for the service is stable. It will
be around as long as car insurance. Copart's competitive position
is solid. I like the management. The balance sheet - which is
chock full of land - is fine. It's clearly a safe stock.
But is it cheap? Copart trades at 21 times earnings. It trades at
over 4 times sales. And the price to book is so high it has no
So I like Copart. I follow Copart. But I don't own Copart. It
only checks one of the boxes I need checked. It is a good, safe
business. But it isn't cheap. And it doesn't promise 10% annual
returns. So I can't buy the stock.
Then there are stocks that are cheap. No one doubts they are
cheap. But are they safe? Are they the kind of business I feel
Bank of America (
. Or even
Whether you can buy these stocks depends on where you draw your
circle of competence. HP is definitely outside my circle. There
is not even a kernel of understanding in that business for me to
latch onto. I don't know their products. I don't know their
customers. I don't see how they differ from others.
And I'm writing this on an HP desktop. But I only own that
desktop because another - non-HP computer - broke. They could
ship an HP that day. So I bought an HP. I don't like or dislike
the desktop. And I wouldn't buy another HP.
A lot of companies - mostly big companies - fall into the HP
category for me. They are big. They compete with other big
companies. And I'm not sure I understand what they do. Why they
make the products they do. Why they provide the services they do.
And why any customer would stick with them.
These stocks may make good bets. It might be a great idea to buy
Hewlett-Packard LEAPs. I don't know. It isn't the kind of stock I
am looking for. Because I'm looking for a business I understand.
Where I understand the company's behavior. And I understand their
customer's behavior. That - more than anything - is what gives me
So no HP for me. No matter how cheap it is. What about Bank of
has a preferred investment in Bank of America. He obviously
thought the common stock was cheap. He got 10-year options as
part of the deal.
I'm a Bank of America customer. And I have no doubt that - in
five years - they will have more of my dollars at their bank than
they do now. That's a good sign.
There are very few businesses that can count on getting more of
my business in the next five years. I'm sure
will make more money off me in 2017 than they do now. I'm sure
will make more money off me. And I'm sure Bank of America will
too. That's about it.
These businesses all have some things in common. They scale well.
They have big competitors. And parts of the experience they offer
Amazon benefits from how little I liked shopping at
. It was never a fun place. Some people like being in actual
stores. I'm not one of them. So Amazon doesn't need to match
stores on price to keep my business. I'm always willing to pay up
a little for the convenience of online shopping, home delivery,
Southwest is a more direct winner. They offer more frequent
flights on the routes I want. They have good prices. And I like
the actual experience a bit more. Again, very big, unimpressive
competition is part of why I can be sure I'll fly Southwest even
more in the future. The alternative is worse.
So why am I sure I'll bank more with Bank of America? It's a
sticky business. It's a big hassle to move. They own a broker -
Merrill Lynch. Online banking is important to me. Their brokerage
and online services can match anyone's. And I don't like going in
a branch. So superior customer service by a local competitor
won't get my deposit.
Finally, the real reason Bank of America has my business is
location. My old bank was Wells Fargo. I liked Wells Fargo better
than Bank of America. I still do. But Wells Fargo doesn't have a
branch I can walk to. Bank of America has one a couple blocks
from my apartment.
Does that mean Wells Fargo can open a branch next door and get
back my business? No. Banking is a sticky business. I moved banks
when I moved. Moving my account for any other reason is a pain I
don't need. Bank of America will have to drive me away with
mistakes. A competitor can't win me over if I'm even remotely
content. Banks are not something people shop for. They are
something they switch only when they need to. Like when their
current bank screws up. Or when they move.
So Bank of America won my deposit with location. They've won a
lot of deposits that way. And even a competitor like Wells Fargo
can't do much to them. In the U.S., every bank has a small share
of national deposits. The competition between big banks - for
deposits - is not as rough as the kind of competition Amazon and
Southwest have to deal with. It's more local. And more
That makes it sound like I could buy shares of Bank of America.
And I could - if all that mattered to a bank is deposits. I have
no doubt Bank of America will get cheap money far into the
The problem is the past. And what they do with deposits. I need
to worry about everything Bank of America did in the past. And
all the loans they will make in the future.
I like to put 25% of my portfolio into one stock. I don't feel
comfortable putting 25% of my portfolio into Bank of America. It
is cheap. And it can return 10% a year. But it's not in my
. This stock is also clearly cheap. And it's also a business
where I have experience as a customer. I'm running Windows 8
right now. I love it. I have no idea what the long-term future of
Windows will look like.
I also have an Xbox 360. And - of course - I use Microsoft
Office. I'm very likely to use all three - Xbox, Windows, and
Office - in their next generations. So Microsoft has their hooks
in me. And in a way HP doesn't. My next desktop will not be an
HP. My next operating system will be Windows.
Microsoft seems like an easy business to understand. And in some
ways it is. But it depends a lot on what computers look like. It
worries me a lot that the line between my desktop and my Kindle
Fire is not a wide one. Windows only has a moat in one of those
I just don't know what the future of computers will be. And
whether there will be a place for Windows. And how big it will
be. So I know Microsoft is cheap. But I'm not comfortable buying
Why did I turn a question about macro investing into a question
about micro investing?
Because that is always what it comes down to. I have 75% of my
portfolio in cash - because I said no to stocks like Microsoft
and Bank of America and HP. Not because I have a view of the
market. Not because I have a view of the economy.
If the stock market was overpriced and the economy was in the
toilet and Carnival was trading for $15 a share - I would buy it.
Why? Because in 20 years, I believe the cruise industry will be
bigger than it is today, Carnival will be the leader in the
cruise industry, and the leader in the cruise industry will earn
its cost of capital. If those things are true - and Carnival is
trading for a fraction of book value - then I should buy
Carnival. Nothing else matters.
The macro picture - by which I mean the level of the stock
market, the strength of the economy, and the level of interest
rates - will change a lot in 20 years. It changed a lot during
the 23 years in which
owned Coke. But if he was right about Coke in 1989 - he didn't
need to be clairvoyant about the future of everything else.
Thinking about the big picture is often dangerous. Because it's
often used as a way to justify dumb decisions. Not clearly dumb
decisions. But borderline decisions. Carnival at $35 a share is a
borderline decision. If you are right about fuel prices - that
they will be lower in the future than they are today - you may
make buckets of money buying Carnival at $35 a share. If you are
wrong, you may not. It's a borderline decision at $35 a share. It
is clearly a good decision at $15 a share.
Waiting is the hardest part of investing. You have to wait long
enough to buy a good idea. And once you own the idea, you have to
wait long enough to see it play out.
Right now, I am waiting for a good idea. And that means I made 5%
this year. And the market made 11%. That's the price of a good
The value of cash is as an option. Cash is an option on future,
lower stock prices. For a market timer - it's an option on
future, lower general stock prices. For a stock picker - like me
- cash is an option on future, lower specific stock prices.
I don't have 75% of my portfolio in cash because I think the
stock market will be lower in the future. I have 75% of my
portfolio in cash because the price of Carnival and Copart and
are not low enough yet.
Those stocks may get cheaper in the future. If they do, I may buy
them. Or they won't get cheaper. And I'll never get to buy them.
The only other option is lowering your standards. Which
refused to do in 1965. Stock prices were too high. He couldn't
find good ideas to buy. It wasn't the game he was used to
playing. So he wound down his partnership.
Why didn't he just stay in cash? Because he was investing for
others. Many of the people reading this article are not
professional money managers. You can live with earning 5% a year
when the market earns 11% a year. That's the advantage you have
over money managers. Use it.
Talk to Geoff about What To Do When Good Stocks Aren't
Read Geoff's Other Articles
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