Eating Sardines and Trading Sardines

When I read a book, there are some stories just stick in my mind at times and become part of my guiding principles in things that I do.

I would like to share this particular story from Seth Klarman’s Margin of Safety – Trading Sardines and Eating Sardines, it serves as a last question on my checklist before I decide to place an buy order on any stock. Here is the extract from Seth Klarman’s book:-

 

There is the old story about the market craze in sardine trading when the sardines disappeared

from their traditional waters in Monterey, California. The commodity traders bid them up and the

price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal

and actually opened a can and started eating. He immediately became ill and told the seller the

sardines were no good. The seller said, "You don't understand. These are not eating sardines, they

are trading sardines."

As stock investment is about the future of the company/business that is full of uncertainty, there is always a risk that we may be wrong in our forecast/prediction/assumptions, whatever you call them, and we may end up losing part, if not all, of our capital. Hence, Margin of Safety is important to minimize our loss if/when indeed we are wrong. It should provide the safety net that we need, similar to the safety net we wish would be there when we fall off the cliff, though there is no guarantee that you will be safe as the net may have holes that we may not see or rotten due to the huge impact that may tear it apart. But it will still provide some cushion to either slow down our fall or sufficient to support us from falling to death.

On of the popular quotes by a great Valued Investor is “pay 50 cents for a dollar” – the simplest way to understand the concept of margin of safety . In order to check if we have margin of safety when we buy a stock, it is inevitable we need to have 2 figures – the price of the stock and the value that we think stock is worth. Hence, valuation is needed. There are basically 3 broad categories ( if you are keen to learn more, please refer to Jae Jun’s The Ultimate Guide to Stock Valuation):-

1. Asset base – Net Tangible Assets/ Net Net Stocks
2. Income base – PE, EV/EBIT, Earning Power Value (EPV)
3. Cashflow base – Discounted CashFlow (DCF)

My personal experience is that, of the 3 categories, PE, EV/EBIT and DCF are the preferred methods among investors. Asset base valuation though is the most reliable method as it involves least assumptions and do not need to project or estimate growth/profit/cashflow, but is usually the laggard for a company in getting to its fair value.

It is also partly due to the fact that we do not expect the company to liquidate and realise the full value of its assets as long as it still continues to operate. Hence, more often than not, we need to wait till the company to unlock its asset value through some corporate exercise (divest non-core/ valuable assets & distribute dividend) or spin it off (eg into REITS).

Now, the 2 important valuations basis -Income & cashflow methods involve some degree of projections, aren’t value investors also speculating about the future? To me, yes, investment is about the future and future is uncertain, hence value investors are also speculating to some extent but on more reasonable and acceptable assumptions that are supported by events/activities that are taking place or about to take place, not mere rumours or hearsay.

Yes, I am kiasi  and always trying to check my safety net first before buying. The worst scenario is I still can open the sardines to eat it if I can’t trade it and nothing will happen to me!