This morning I read some comments by a notable fund manager. He was discussing recent weakness in the share price of Natuzzi, the world?s largest leather upholstery manufacturer. At one stage he asked the question of what multiple should one pay for Natuzzi. I will quickly explain. The multiple or PE (price/earnings ratio) you pay, basically relates to the quality of future cash flows. This again is a function of growth and certainty. If cash flows are expected to grow in future then you can pay a higher multiple. If those growth expectations are uncertain then you should adjust the multiple downwards. I find it easier to understand if I use the inverse of the multiple, which is the yield. A PE of 10 (10/1) equals a yield of 10% (1/10). If you wish to get 15% out of your investment over the long term then you might be willing to settle for 10% now if it looks like the future cash flows of your investment will grow and if it there exists great certainty that it will actually grow according to your expectations. Anyway, so there I was pondering the comments of the fund manager. Normally an answer to a question of what multiple you should pay would focus on the size and quality of the future cash flows. However, the context in which the question was asked related more to how low he thought the market would go. My immediate reaction was; hey buddy that?s the wrong question you are asking. He was second-guessing the market and that is a fruitless exercise.

Then I caught myself. It so easy to spot the mistakes of others, isn?t it? I never try and figure the market. I just try and get to the point where I feel I have a very good idea of what the worst-case scenario for the future cash flows look like. Then I discount those cash flows at my required rate of return and if I am offered an acceptable margin of safety then I buy. Yeah, I wish. I don?t think there is one occasion where I don?t think one of two things. One, will the share price go higher or two, will the share price go lower. If the recent trend was up then I will think one, and if down then two. Big mistake. The right way to do it is simply to buy when the price is right. Yes, so you are going to miss out sometimes. Take my experience with Natuzzi as an example. I made my first investment at $9.05. The shares promptly (and I mean promptly as in about two weeks) went down to $7.13 or by 21%. So at around $7.49 I doubled up. The share recovered just as quickly as it went down and closed at $8.99 on Friday. My average cost is $8.30 so I am already sitting on an 8.3% gain and I have been invested for less than a month. The reason I doubled up, when I did, was that I received some new funds. The fundamentals of Natuzzi did not change so I perceived it to be an even better deal than at $9.05. I?m good hey? If you thought that it is only because you know half the story. Lets go back to my purchase at $7.49. The share price was in general decline for the last couple of months and weeks. So if this letter were written at that time you would have thought that I looked pretty stupid. At any rate, I felt like a twit. A number of thoughts raced through my head; will it go lower? Will it go down by another 21%? What if some big fund started buying? Yeah, I know it is a good deal, but that is what I thought two weeks ago when I paid $9. However, it will be a steal at $6.50. Essentially I am was asking what the market thought of Natuzzi and that answer lies buried deep in the psychological profile and personal circumstances of the millions of us that make up the market. Then I thought that if I were to be right about Natuzzi then it would be because the facts made me right not because I judged the market correctly. Of course that bit of wisdom does not come from myself, no it is the Master speaking once again. Thank you Benjamin Graham. So I invested and now I look like a genius. That is short-term reprieve. I am a long-term investor. The main factor that will determine whether things go according to plan will be if the future cash flows turn out according to plan. That will take at least three to five years to determine. My little exercise in mental constipation will be long forgotten by then. Never mind the fact that it felt extremely relevant at the time.

As long as your questions on multiple seek answers that relate to future cash flows then you are doing fine. However, if you are trying to sense the direction of the market then you are wasting energy and precious time that can be better spent elsewhere. Personally, I find myself heading for that trap ever so often. Hopefully you, like me, will head for the Graham First Aid kit for investment headaches. Or maybe you can do even better that by just banishing any inclination to try and time the market?forever.

If not then just simply reach into Graham?s First Aid kit for investment headaches and take one pill from the bottle of which the label reads, ?Market timing?. You will soon remember that you can only be right, if the facts make you right.

It really works. I should know. I go through about one bottle per month.

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2003/03/24 09:48 View Archive