“Portrait of a Disciplined Investor,”- Business and Investing
“Investors are going to make out a whole lot better if their whole emphasis is on owning businesses.”
“Even the world’s greatest business is not a good investment, if the price is too high.”
“When you ask whether someone is a value or growth investor – they’re really joined at the hip. A value investor can be a growth investor because you’re buying something that has above-average growth prospects and you’re buying it at a discount to the economic value of the business.”
I picked this quotation to start this blog post to illustrate how Lou Simpson and Warren Buffett “think alike.” Here’s Warren Buffett on the same point: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive…. Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”
The idea that an investor might buy a stock regardless of whether it is available at a bargain price simply because the business is growing is foreign to both Buffett and Simpson. Charlie Munger agrees: “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle.” What you want to find is a bargain, which takes a lot more work that just finding a business that is growing revenue a lot. There are some very high quality growing business that you would be nuts to buy at a high enough price and equally nuts not to buy at a low price. A high growth asset can be very risky if you overpay for it. Howard Marks points out: “When someone says, ‘I wouldn’t buy that at any price,” it’s as illogical as, “I’ll take it regardless of price.’”
“Invest in high return businesses run for the shareholders.”
“Return on capital. That really tells you a lot. One of the basic problems is that there is so much noise around earnings that you really have to rip apart the financials to understand what the real numbers are. It’s really the basic returns on equity capital [that are] important, but sometimes they’re not obvious. Even so, I think you have to look at a lot of things. You have to figure out what the earnings growth rate of the company will be over an extended period of time, and then apply a discount rate to it so you can come up with the best valuation. It’s easy in principle but it’s extremely difficult in practice.”
One of the four bedrock principles of Ben Graham–style value investing is that a security represents partial ownership of an actual business and should not be treated as a piece of paper to be traded based on investor psychology. This means that understanding the business itself is essential to understand the value of a security. To be a value investor you must dig deep and do research on how the business operates, its markets and its competitors. Charlie Munger argues: “All intelligent investing is value investing — acquiring more than you are paying for. You must value the business in order to value the stock.” If you find this process boring or can’t find the time to do it, it is very unlikely that you will be a successful investor.
Ben Graham once said: “Investment is most intelligent when it is most businesslike.” What he means is that to understand a stock or bond you must understand not only the business but business generally. Seth Klarman in a Charlie Rose interview once said: “I think Buffett is a better investor than me because he has a better eye towards what makes a great business. When I find a great business, I am happy to buy it and hold it. [But] most businesses don’t look so great to me.” Daniel Kahneman has a nice take on this point arguing that people like Lou Simpson or Warren Buffett are not in the business of stock picking; they pick businesses and managers. Lou Simpson again: “One of the things I have learned over the years is how important management is in building or subtracting from value. We will try to see a senior person and prefer to visit a company at their office, almost like kicking the tires. You can have all the written information in the world, but I think it is important to figure out how senior people in a company think.”
“Pay only a reasonable price, even for an excellent business.”
The second bedrock principle of Ben Graham-style value investing is that a security must be purchased at a sufficient bargain to intrinsic value that it provides the investor with a margin of safety. Buying securities at a significant discount to intrinsic value (e.g., 25%) creates a margin of safety which can protect against mistakes. In an ideal situation a value investor feels like they are “buying a dollar for 50 cents.” This opportunity does not happen often, but when it does, the value investor should load up the truck (buy a lot of the asset; bet big). If you have a margin of safety when buying assets you don’t need to precisely predict intrinsic value. Roughly right is enough and far better than precisely wrong. Securities that represent a partial interest in some businesses are selling at a price that is significantly less than their intrinsic value and some are not. Paraphrasing Seth Klarman, at one price a partial interest in a business “is a buy, at another it’s a hold, and at another it’s a sell.” When you buy a partial stake in a business at a price that represents a margin of safety you can make an idiotic decision and sometimes still do OK. And when you are right you can do even better financially.
“Think independently. We try to be skeptical of conventional wisdom and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.”