Friday, June 8, 2012

Buffett: Buying Cash Flow at a Discount

From a lecture given by Warren Buffett to Notre Dame faculty, MBA students, and undergraduates in 1991:

If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it's worth. It doesn’t make any difference whether you sell yo-yo's, hula hoops, or computers. Because there would be a stream of cash between now and judgment day, and the cash spends the same, no matter where it comes from. Now my job as an investment analyst, or a business analyst, is to figure out where I may have some knowledge, what that stream of cash will be over a period of time....

Buffett uses Digital Equipment* as an example of a business that he doesn't know its prospects in a week never mind longer term. If the lecture had been in 2012 a more relevant example would be used but, of course, that's kind of the point (twenty plus years sure is a long time in technology).

He adds that he does understand something like Hershey bars. What's not at all surprising is that Hershey's (HSY) business has done just fine. Including dividends, an investment in Hershey's stock is up roughly 1,000 percent (though the stock does seem somewhat expensive these days) since around the time of that lecture.

Buffett later added:

So, my job is to look at the universe of things I can understand...and then I try to figure what that stream of cash, in and out, is going to be over a period of time, just like we did with See's Candies, and discounting that back at an appropriate rate, which would be the long term Government rate. [Then,] I try to buy it at a price that is significantly below that. And that's about it. Theoretically, I'm doing that with all the businesses in the world – those that I can understand.

Every day, when I turn to the Wall Street Journal...that’s like a big business brokerage ad. It's just like a business broker saying "you can buy part of AT&T for this, part of General Motors for that, General Electric..." And unlike most business broker's ads, it's nice because they change the price every day. And you don’t have to do business with any of them. So you just sit there, day by day, and you yawn, and you insult the broker if you want to, and talk to your newspaper, anything you want to, because someday, there's going to be some business I understand selling for way less than the value I arrived at. It doesn’t have anything to do with book value, although it does have to do with earnings power over a period of time. It usually relates, fairly closely, to cash [flow]. And, when you find something you understand, if you find five ideas in your lifetime and you’re right on those five, you’re going to be very rich.

Some investors focus on finding superior growth and the next big idea to produce returns. There's no problem with that approach (many are very good at it), of course, if the range of likely business outcomes is frequently judged well and prices are paid that provide some protection against the uncertainties.

This is especially important if it happens to be a fast-growing but less proven enterprise. It's easy to get caught up in the possible upside of something new and exciting in a way that due consideration of downside possibilities get shortchanged.

Whether a business is growing fast or not, it's all-important that an investor pay much less than what is a realistic assessment of discounted future cash flows. When returns are dependent on assumed high growth rates to justify the price paid, the risk of permanent capital loss becomes unacceptably high if those growth rates don't materialize.

The more dynamic the business and the industry it resides in is, the harder it is to estimate future free cash flow. Even small adjustments in growth rate assumptions have meaningful valuation implications.

The likelihood of getting it very wrong much greater.

In contrast, there's no shortage of proven durable and, yes, sometimes rather boring businesses where estimating what the future cash flows are worth in present dollars is actually relatively simple. An investor only has to understand a very small number of them and have the discipline to wait until one of them sells for a whole lot less than the value (margin of safety) they've arrived at.

Above average risk-adjusted returns are possible without spectacular business growth. It's easy to underestimate this.

Each of these businesses will naturally have its own unique set of risks, threats, challenges, and of course opportunities. With the best, the competitive landscape is rather stable and they have pricing power or a durable cost advantage.

Growth is of minimal importance and sometimes it is the lack of growth prospects that keeps competitors from coming in and disturbing the economic equation.

The hardest part can be the amount of waiting that's involved once you've done your homework and gotten comfortable with a business. It may be a long time before a nice discount emerges for the shares of a business you understand.

In other words, it's more about patience, discipline, and temperament than some brilliant insight.

So find an attractive business, develop an understanding of it with some level of depth, estimate the (even if in some cases somewhat uneven during the business cycle) stream of free cash flow it will produce over time, then discount that cash to value it appropriately.

Beyond that, wait for the shares to sell for a lot less than what that discounted stream of cash is worth in current dollars.

Simple.

Not easy.

Adam

* Bought by Compaq then later merged into Hewlett-Packard.
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