“Investing is simple, but not easy.”
Warren Buffett
The purpose of investing is to lay out some money today in order to get back more money in the future. Pretty simple, right?
There are countless ways to invest money today in the hopes of collecting more money in the future. There are flaws in every single one of them. The most logical and economically accurate approach is to compare an asset’s intrinsic value to its price in the market. For those unfamiliar, intrinsic value is simply the cash flows available to an investor that an asset produces over the course of its lifetime, discounted back to the present. Understanding intrinsic value is essential because it provides a standard measure of an asset’s worth, enabling an investor to weigh the prospect of future money in exchange for today’s money. Investing without an estimate of value is akin to embarking on a road trip without first checking the gas gauge; you might make it to your destination, or you might find yourself on the side of the road in the middle of nowhere.
The most basic, fundamental variables that influence an asset’s intrinsic value are its cash flows, growth, and risk. That’s it. When it comes to businesses, cash flows are the actual dollars leftover after deducting all cash costs and business investments. Because such costs and cash flows can vary in their magnitude and timing, a measure of earnings is commonly used as a proxy. In the very long run that should be adequate, but in short run, earnings can be manipulated to make an excellent business appear poor or a poor business appear excellent. Because cash flows are generated over the asset’s lifetime, growth is important for the trajectory of the cash flows, with cash in the future being less certain and less valuable than cash in the near term. To be beneficial, however, growth must coincide with value creation, or a return on investment greater than the cost of capital. Broadly speaking, risk reflects the discount rate for the cash flows. There is no precise way to calculate a business’ risk, but it should reflect riskiness relative to other assets as well as intrinsic to the company. Every investment rationale boils down to these three factors and a comparison to price. Therefore, reasoning from these first principles is the basis for all sensible analysis.
Attempting to identify assets priced meaningfully below their intrinsic value is a core pillar of what is traditionally known as value investing.* The concept of value investing originated with the teachings of Benjamin Graham, known as the father of security analysis and value investing, and later became popularized by Warren Buffett, widely considered to be the greatest investor of all time. It is noteworthy that Buffett’s investing tactic has evolved over the decades from following the Graham playbook of buying statistically very cheap but poor businesses, to buying wonderful businesses at fair prices, in large part due to the influences of Phil Fisher and Charlie Munger. Often, he’s purchased entire businesses to operate within the Berkshire Hathaway conglomerate. Yet despite the evolution in capital allocation, Buffett has always adhered to the value investing philosophy, which at its core is buying something for less than it’s worth. Rather amusingly, Buffett and Munger have pointed out that “value investing” is an oxymoron; what is investing if not attempting to get more value than for what you pay?
When asked about investing, Buffett has repeated the Aesop proverb that “a bird in the hand is worth two in the bush.” The challenge, he adds, is determining how many birds are in the bush, what is the probability you’ll get them out, and when. In most bushes, the birds are easier than ever to spot and capture. And with a greater number of participants observing the same bushes, the probability of capturing more birds undeniably decreases. What is relatively unchanged, however, is the variability in value participants place on the bird in the hand. Sometimes, birds are released rather carelessly in the optimistic anticipation of capturing just a few more birds; while at other times, you couldn’t pry a bird out of someone’s hands no matter how high the probability is of capturing many more. Placing greater value on the bird in your hand when others are eagerly releasing theirs may be the difference between survival and starvation in the event of an unexpected exodus of birds from the bush. Inevitably, though, the birds always return, and mate rather aggressively. For those willing to relentlessly search, particularly in places where others are not, with a bit of luck, spotting an unnoticed full nest can be quite rewarding.
Investing is more of an art than a science, and similar to real art, beauty is in the eye of the beholder. It is precisely because there is no formula or strategy that works all the time that makes the game interesting. Ultimately, investing is simple, comparing value and price, but certainly not easy since anybody can pinpoint price yet nobody can pinpoint value. It is an exhilarating, agonizing, and humbling endeavor to scour the landscape for bushes auspicious enough to give up a bird. At the same time, though, is it not human nature to explore the unknown, intellectually or otherwise, in an attempt to discover what few others have?
* The term has unfortunately morphed over time with the advent of factors.
Reflections on Investing 