Wednesday, February 20, 2013

Aesop's Investment Axiom

According to Warren Buffett, the formula for valuing an asset purchased for gain is the same now as it was when articulated by Aesop long ago.

From the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.

Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. 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. Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation."

Somehow a distinction between growth investing and value investing is frequently still made.

It's a distinction without a real difference.

Some will no doubt disagree.

Investing well over the long run requires many things, of course. Yet it ultimately depends upon understanding how to judge correctly, within a useful range, what something is worth -- regardless of its growth profile -- then paying an appropriate discount for it.

The necessity for a discount reflects the inherently imprecise nature of judging value. It also reflects the fact that not everything that's important can be known and misjudgments will inevitably be made. Simplistic valuation metrics like price to earnings are only useful if they happen to be a meaningful proxy for the amount of future net cash an investment will likely generate.

Unfortunately, that's often not the case.

More from the letter:

"...Aesop's proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let's call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights."

How much cash will be generated, when it will generated, and what the prevailing risk-free interest rate is what's all-important. Once there's a meaningful estimate (within a range), the amount and timing of cash flows can then be discounted using an appropriate interest rate.

So it's not, as some might think, growth per se that's necessarily important.

If interest rates are very high, the cash produced in the future needs to be available to the investor sooner than later.

If prevailing rates are very low, the investor can afford to wait quite some time for that cash.

The investment process ultimately rests upon the foundation of knowing how to judge what something is worth consistently well. Lack that ability and everything built upon that foundation crumbles. Others skills and abilities won't be able to compensate for that shortcoming.

Otherwise, it comes down to thinking independently, an even temperament, discipline, and an awareness of limitations. It's less about IQ than some seem to think.

A speculator will, of course, have an entirely different way of looking at this. For a speculator (with a long position, of course), a large drop in the price of an asset is not a good thing. For an investor, a large drop in the value of an asset is not a good thing.

A drop in value means that the net cash to be produced over the life of an asset was misjudged.

A drop in price may mean the psychology of the market has changed (though it surely could also reflect fundamental factors). A temporary drop in price will be a good thing for the investor who's judged value well.

Speculators try to gauge price action. In general, they try to figure out what someone else will be willing to pay in the future.*

That certainly doesn't mean there's something inherently wrong with speculation. There isn't.

It's just that there is a real difference -- in both required skill set and temperament -- between trying to figure out what others will pay for an asset at some later time, and figuring out what an asset itself can produce over its useful life in economic value.

From this interview with Warren Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

Let's hope we don't always have to go back 2,600 years or so to find investment wisdom.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Aesop's Investment Axiom Revisited - Jul 2014 (Follow up)
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
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 Aesop's Formula for Value - Nov 2009
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

* This doesn't mean no fundamental factors influence a speculator's decision. The difference between investment and speculation is subjective -- far from black and white -- but still very real. It's a matter of proportion, emphasis, and time horizon. Investment and speculation can be considered similar only if one's definition of similar is rather imprecise.
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