Mistermarket has posted a terrific post on the Motley fool Berkshire Hathaway Board. A good summary of graham – buffet principles
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In honor of Ben Franklin’s The Way to Wealth, I recently decided to follow Franklin’s format and draft an allegory that pertains to intelligent investment. For those unfamiliar with Franklin’s The Way to Wealth, do yourself a favor and go buy it over the holiday. Otherwise, I hope you enjoy an updated, albeit, slightly skewed format and context.
Happy Holiday.
Mistermarket
Courteous Reader,
I should like to recount for you the events and dialogue, which I observed recently in mixed company. As has been my practice for several years now, observing the market on a daily basis, I consider my self-education to be rather well versed on the general investment philosophies of today and yesterday. Moreover, considering the voluminous data and often conflicting information generated by the financial markets, I regarded myself most fortunate to have happened upon the forum that I am about to describe to you. The investment insights shared herein remind me that the fundamentals are critical to intelligent investment and serve as confirmation of Charlie Munger’s claim that all intelligent investing is value investing – to acquire more than you are paying for.
“Recently, I was seated on a train where a great number of people were collected en route to the financial district. Of those on the train, the usual suspects were present, the same group of suits and ties that I’d seen on a daily basis for years; some gregarious, others pensive and aged from young to old. While some were discussing current economic and market dilemmas, others were upbeat and euphoric. While I rarely joined these boundless debates, I was even more aware of an older gentleman with silver hair who was always merely a spectator. One from the crowd called to the unassuming old man, “Say, Henry, you’ve been around a long while, what do you think of the times? Won’t these large deficits and weak currency ruin the market? How shall we ever make any money? What advice would you offer?” Henry looked around at the faces he’d seen many times before, and replied, “If you’re interested in my advice, I’ll give it briefly, for as Poor Richard said, ‘A word to the wise is enough.’1” The crowd in the train car became deathly quiet as all eyes turned to Henry. As he looked about at all the faces, he could tell that his initial reference did not register and he knew it would take more than a few words.
“Gentleman,” he said, “and ladies, the deficits are certainly very large, and currently the currency is weak, and while these topics are of interest, do they really matter in terms of investment decisions of individual securities? Some of you may think so, but I would suggest there are far more important things to focus on, beginning with a simple philosophy. As far back as 1934, Ben Graham wrote in his book, Security Analysis, ‘An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’2 More recently, Warren Buffett, who originally trained under Graham, has said, ‘
Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.’
3 Furthermore, in terms of an investment philosophy, Ron Muhlenkamp has said more specifically the objective should be to, ‘Maximize total return . . . through capital appreciation, and income from dividends and interest, consistent with reasonable risk.’
4- As old Henry glanced at his audience, he noted with some surprise that they seemed wholly unfamiliar with such prime notions, so he carried on:
“While such related ideas may seem basic, and they are, the business of investments can quickly become quite overwhelming without a few guiding principles such as the aforementioned. Furthermore, since our time today is limited, and you’ve asked for my advice, I’ll further narrow my comments to the business of investments in equity securities or stocks. The business of investments in stocks requires one to effectively analyze securities, both individually and relative to others, and additionally one must consider the effect of taxes and inflation on an investment opportunity.“First, to the business of investment in individual stocks. While there are several things that may pique one’s interest in a stock, it is important to note the trite saying of Warren Buffett’s, ‘Price is what you pay. Value is what you get.’
5 And Phil Fisher further added, ‘The stock market is filled with individuals who know the price of everything, but the value of nothing.’
6 In the successful business of investments, the price one pays will always directly factor in the ultimate return. By beginning the discussion with purchase price in mind, one is simply following the advice of the famous algebrist, Carl Jacobi, who frequently counseled, ‘Invert, you always invert’. By doing so, one works backwards with price in mind to determine whether the intrinsic value of a security warrants consideration of a purchase, relative to the current market price. The concept of intrinsic value largely began with Graham who generally attempted to differentiate a businesses value from its market price. Obviously the idea was oriented around exploiting differences where the fundamental value of a business on a per share basis was greater than the current market price of the security itself. However simple the notion, the concept of intrinsic value escapes an exact definition. Buffett has said of Graham’s concept of intrinsic value, that ‘There is no formula to figure (intrinsic value) out. You have to know the business (whose stock you are considering buying).’
7 Further, Buffett has cautioned that, ‘Valuing a business is part art and part science.’
8, which echoes a comment by Graham who suggested, ‘The work of a financial analyst falls somewhere in the middle between that of a mathematician and an orator.’
9 -You may ask of me, this is all quite nice, but what does it really mean? A perfectly reasonable question and further explanation I shall offer.”“Perhaps a simpler concept which correlates to intrinsic value is Aesop’s sage counsel offered in 600 B.C. that ‘a bird in the hand is worth two in the bush.’ Buffett has explained Aesop’s principle the following way, ‘To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate? If you can answer these three questions, you will know the maximum value of the bush, and the maximum number of birds you now possess that should be offered for it. And, of course, don’t literally think of birds. Think dollars.’
10- “What Buffett is really suggesting is that intelligent investment requires some reasonable assumptions and the use of rather basic time value of money principles. In terms of specific investment opportunities, one should consider the current assets, liabilities, and equity of a company, but just as important are the likely future cash flows of the company. While the balance sheet of a business is helpful with the first three items, future cash flows are based upon assumptions and although we are all familiar with what assumptions can lead to, there are valuable metrics generated by a business that are helpful to this part of the exercise. The first of these is the profitability or earnings power of the business. How much profit is the firm generating and what is the past earnings history? A five to ten year period is very helpful in showcasing the ability of a company to consistently generate and expand earnings. Additionally, and just as important is return on equity or how well the companies management can deploy the earnings of the operation. Further yet, one should always review the price-to-earnings ratio as a sort of litmus test to determine the premium that the market is charging for current earnings of the company. Therefore, one should be constantly searching for companies that are profitable and efficient and whose shares are selling at valuable prices.”
“The entire valuation exercise is of little material significance until compared to the price the market establishes for a stock. Only then does one get a sense for what value might be realized with an investment. So we have Graham’s notion of intrinsic value that seeks to place a value range on a business using time value of money principles applied to a businesses assets, liabilities, equity and likely future cash flows based upon the historical earnings and ROE of a business. When comparing the value range to the market price, one begins to understand Graham’s distilled secret of sound investment – MARGIN OF SAFETY. Just as an engineer designs redundancy (backup) into a system or excess capacity into a bridge, the intelligent investor should always attempt to build a margin of safety into the their investments. To conclude this section on business valuation within the context of intelligent investment, further commentary from Graham himself is beneficial. For Graham said, ‘The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, and nonexistent at some higher price…It is available for absorbing the effect of miscalculation or worse than average luck.’
11-”“Now that one has insights into the general notions of intrinsic value and margin of safety, I shall turn my focus to taxes and inflation, both of which impact an investors return. Although important, I mention these items secondary to the preceding discussion because of the impact these variables have on the return of any given investment post-purchase. Just as the notions of intrinsic value and margin of safety are paramount during the investment selection and purchase process, understanding the impact of taxes and inflation on an investment post-purchase is equally important. To further amplify the importance of these variables one should consider the related comment from Charlie Munger who said, ‘Understanding both the power of compound return and the difficulty in getting it is the heart and soul of understanding a lot of things.’
12 While true indeed, one need not say much of the effect that taxes can have on the realization of an investment return, and yet the frictional costs of activity leading to taxable events can often be more detrimental to the long term compounding effect. For each taxable event, the intelligent investor is then charged the frictional cost of the croupier’s take, as well as the necessity to seek out new investments to replace the discarded. The aggregate effect of all these costs can be a dramatic decrease in the desired effect of compound return. To the point of taxes and compound return, Munger has further suggested that, ‘The objective is to buy a non-dividend-paying stock that compounds for 30 years at 15% a year and pay only a single tax of 35% at the end of the period. After taxes this works out to a 13.4% annual rate of return.’
13 While the capital gains tax rate has changed since Munger offered this advice in 1996, the point is well made and the unspoken suggestion is that higher turnover, higher transaction costs, and cumulatively higher taxes all impair the intelligent investor’s return. In addition, Buffett has alluded to the nature of compounding and indirectly advised on the proper psychology for the intelligent investor when he reiterated a lesson learned from his mentor Graham, ‘In the short run, the market is a voting machine but in the long run it is a weighing machine.’
14 In other words, one must have conviction in their analysis in order to make investment decisions in the short run that may seem unpopular with current market sentiment, and by establishing a longer investment time horizon the investment has a better opportunity to compound returns. It has already been suggested that during the investment selection process, one should focus on conservatively financed companies, with profitable operations ideally consisting of expanding earnings and high returns on equity. Buffett has confirmed the key role of time in investment selection process and quest for compounding returns, ‘Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.’
15 Such concise anecdotal commentary should adequately illuminate the benefits of lower turnover, lower transaction costs, lower taxes and thereby the benefits of compounding on nature of investment returns. Yet, the intelligent investor is still not free and clear from one very important, but abstruse investment obstacle – inflation.”“Inflation is a monetary phenomenon that indirectly, but acutely, impacts the investment objectives of the intelligent investor and all wise investment professionals have identified inflation for its potentially disruptive nature. Because inflation is a monetary phenomenon, its cause is largely tethered to the money supply, which is controlled by the Federal Reserve Bank of the United States. The Fed also sets the interest rates for the Fed Funds Rate, the rate that banks are charged for overnight loans. The machinations of the Fed send a ripple effect throughout the markets, which ultimately impacts the intelligent investors operations. On the importance of interest rates Buffett has said that interest rates are the foremost economic variables that impact stock prices. The effect of interest rates in the markets and in the value of all financial assets, from stocks and bonds to real estate and commodities, is quite evident. And the effects on valuations can be significant. While Buffett makes a pointed comment about interest rates and their impact on the value of all assets, Ron Muhlenkamp has further identified the pervasive impact that inflation has on the intelligent investor. ‘When the value of money changes, it changes everything valued in money.’
16 Muhlenkamp has succinctly noted. He adds, ‘Everything measured in dollars is measured by the inflation yardstick,’
17 and cautions, ‘The effects of inflation can easily be overlooked because inflation shrinks everyone’s yardstick. Over time, the effect of inflation on our money can be tremendous. We can’t afford to overlook it.’
18 Obviously, taxes and inflation have potentially dramatic impacts on the ultimate return sought by the intelligent investor and should be factored sensibly in the process of investment selection and management.”“Well friends, I have taken nearly all your time this morning. My own knowledge has been improved by the very insights I’ve called upon and shared with you today, and while the dialogue offered is not thoroughly comprehensive, the highlights are of great importance towards successful intelligent investment. In summary, our journey has started with the exactness of a market quote in mind, and traveled backward identifying along the way several key, if not exact, elements that the intelligent investor must consider and evaluate in his or her quest towards superior investment returns. From the general concepts of intrinsic value to margin of safety, to the more specific metrics of profitability and earnings, return on equity, and price-to-earnings, one can understand the importance of understanding the individual business when seeking investment opportunities, which is more consequential than focusing one’s attention on the complex and indirect nature of deficits and currencies. Furthermore, our journey has covered the importance of compounding and how extended time horizons can be an added benefit to the nature of compounding. Additionally, the potentially disturbing impact of trading, taxes and inflation should be quite evident to the intelligent investor. While the notions I have shared herein are not my own, and require one to be analytical, both in terms of objective facts and more qualitative assessments, they may effectively serve as fundamental tenets of intelligent investment.”
“To conclude, I shall call upon the wisdom and insights of Graham once more for he eloquently summarized that, ‘Investment is most successful when it is most businesslike.’
19 As well, Buffett has said, ‘Read Ben Graham and Phil Fisher, read annual reports but don’t do equations with Greek letters in them.’
20 Investments are a serious business and should be treated as such. So handle your affairs in a businesslike manner and further educate yourself through a lot of reading. One also benefits from noting Poor Richard’s observations from many years ago, ‘Experience keeps a dear school, but fools will learn in no other, and scarce in that, for it is true, we may give advice, but we cannot give conduct’
21, as Poor Richard says. However, remember this, ‘they that won’t be counseled, can’t be helped;’
22 and farther, that, ‘if you will not hear reason, she will surely rap your knuckles’
23. In our case friends, if not our knuckles, then at least our portfolio returns.”Accordingly, Henry ended his speech and walked briskly from the train, full of purpose and resolve. The attentive group heard the address and acknowledged the principles. Yet they all hurried off to their posts and immediately practiced the opposite, for the market opened, and they began to buy recklessly, notwithstanding all his cautions. I found the old gentleman to be very well versed in the fundamental aspects of intelligent investment, as well as the nature of markets. I was little surprised to realize that the quiet man had so much to offer, even if what he offered were not all his own insights, but that of others. However, I determined that I had benefited from the old man’s offering and resolved to work a little longer, a little harder and a little more efficiently by not straying from the philosophies of intelligent investment.
Mistermarket
December 24, 2004.