Friday, January 18, 2013

Buffett: Stocks, Bonds, and Coupons

In the 1992 Berkshire Hathaway (BRKashareholder letter, there's a condensed version of how John Burr Williams described the equation for value in his book The Theory of Investment Value back in the 1938.*

Warren Buffett explained it as follows in the 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."

Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds generally have future cash flows defined by the coupon and maturity date unless there's a default of some kind. In contrast, the equity 'coupons' have to be estimated by the investor.

"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"

The size and duration of those 'coupons' have a much wider range of possibilities. More from the letter:

"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..."

It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**

If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.

Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.

Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)

Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.

In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway shareholder letter:

"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."

Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.

Insufficient margin of safety.

Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.

Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.

So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.

How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable"  compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.

Awareness of limitations.

"An investor needs to do very few things right as long as he or she avoids big mistakes."

The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.

Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.

Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* First written as a Ph.D. thesis at Harvard in 1937.
** The Berkshire Hathaway owner's manual provides a useful explanation of intrinsic value.
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