Friday, October 21, 2011

Buffett on The Theory of Investment Value: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1992 Berkshire Hathaway (BRKashareholder letter:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons."

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success. 

So...
  • Value comes from cash flows discounted at an appropriate rate.
  • The lowest price that can be paid relative to the discounted value of cash flows is what matters...not growth.
  • Superior businesses can employ large amounts of incremental capital at a high return but are rare.
  • The math is not difficult but get outside your circle of competence misjudgments of future coupons will happen. Stick to businesses you can understand.
  • Always make sure a substantial margin of safety exists.
Try to figure out where gold fits into all of this.

The above nicely combines what matters in an investment whether stock, bond, or real estate. Basically, any asset that can produce a stream of cash flows (something gold is not going to do). None of it sounds (or is) difficult to understand but staying disciplined about this stuff certainly is not necessarily easy. Consider this:

"More insurers don't copy BRK's model (underwriting for profit and stepping out of the market for extended periods of time when pricing is bad) because our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

I think when some come to learn how Buffett and Munger approach investing, they make the same mistake that other insurers make. They think there's got to be more to it. It also sounds too straightforward so they underestimate how difficult it is to do things like what Buffett describes above consistently well.

I.Q. may matter to an extent but is trumped by discipline and temperament.

Adam

Long BRKb
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