Robert W. Bruce Lectures 2004-2007 to Bruce Greenwald's Columbia ClassVW Staff
novice analysts and investors naively assume that almost all companies can be valued by them. Investing experience will ultimately crush such hubris and naiveté.
Warren Buffett’s definition of Intrinsic Value Of Permanent Value: The Story of Warren Buffett, pg. 933): Intrinsic value is the discounted value today, of all future distributable cash generated by an entity less the additional capital, including retained earnings that the owners must put in to generate that cash. A simple way to get to how much a company is worth is to ask how much you would get for it if you sold it today.
A very interesting characteristic of some of my companies like Coke is that they can grow without the addition of much of the owners’ capital, which remember, includes retained earnings. This, by the way, means that Coke can take its excess cash and repurchase its shares, such that Berkshire’s original 6% stake is now 8%.
If your discount rate is 10%, you are saying you have the low-risk alternative of putting $10 in, say, government bonds that will pay you $1 of interest, which never grows. But if you have a company that has $1 in distributable cash that will grow 5% per annum forever, you might be happy to own that company and pay up to $20 for it. If that cash grew 8% a year forever, you could pay up to $50 for it. If it grew 9% a year forever, you might even pay up to $100 for it. What you are paying as a multiple of cash flow is equal to 1 divided by (the discount rate less the growth rate). Multiple = 1 divided by (k-g). (Of Permanent Value: The Story of Warren Buffett)
Unfortunately, not nearly as many companies can be valued fruitfully. A fruitful valuation is in a narrow enough ban that the range would help you make an investment decision. For example, if you look at a company and you come up with a conclusion that the values ranged from $20 per share to $200 per share that is not a useful valuation. The reason you can’t tighten up the valuation range may be because the future cash flows of the business may be too inherently unpredictable or it may be that YOU do not have enough knowledge to adequately project the cash flows to value the business.
You may not have enough industry knowledge to come up with an adequate valuation to make an investment decision. This is an important idea, because one thing that underlies the kind of value investing everything that I do is self-awareness. The awareness that you don’t know everything is important. There is a lot you don’t know. There are experts in lots of areas you might be looking and you should be humble and say you don’t know enough to make the investment or do the analysis, therefore, I will cast it aside and move on to something where I may have the knowledge.
I and others like me are always looking for an edge. We don’t want a level playing field. When I buy I want to know more than the guy on the other side of the trade. The other person knows less about that security than I do. If I don’t have that feeling of confidence; if I don’t think I have been very honest with myself, then I step aside. There are a lot of arrogant people in this business, quick studies who think they can run nimbly from one hot area like oil & gas to another like Biotech. I have learned the hard way that I can’t do that.
So the idea is to stick with what you know and be honest with yourself about what you know. Stay within your circle of competence. If you look at our holdings, you will see they fit specific financial characteristics or industries. Charlie Munger has a concept where each of us has one in-box (represents ideas) and three outboxes: a yes box, a no box, and then there is a too tough to call box, which is where you put most things. You must be honest enough to say I don’t know enough to make a reasoned decision so I will pass. This is the concept expressed by Warren Buffett of waiting for a fat pitch and letting the balls go by with no called strikes. If you don’t have the knowledge or insight, don’t do anything. Moreover, you don’t have to make a decision you don’t know enough about.
Buffett on learning from Ben Graham: In applying Ben’s guiding principles, Charlie and I try to be thorough and methodical. We must also be realistic. We look for businesses we can understand, where we’re familiar with the product, the nature of the competition and what might go wrong over time. We try to figure out whether the economics of the business–including its earnings power over the next 5, 10 or 15 years–is likely to resemble a fine wine–to be good and getting better. Then we decide whether we would be buying into a business managed by people we feel comfortable being in business with–people with intelligence, energy–and most important–integrity.
II. How big a discount from intrinsic value is big enough?
Depending on the accuracy and confidence of your valuation of intrinsic value, the bigger the discount you buy the security, the better. There are practical limits, however. If you want to buy at 1/3 of your appraisal of intrinsic value, that would be an admirable approach, however, you might have to wait 10 years before you could find such a discount. Except for 1974 and 2008/2009 when stocks were incredibly cheap, I haven’t been able to find stocks below 1/2 intrinsic value.
Usually, when you think you find securities at 1/2 or less of your appraisal of intrinsic value, go back and check your work–you will find that you are probably making a mistake. My experience has been to use a 33% discount to intrinsic value to enable me to find a useful number of ideas. Now, there is nothing magic about buying a stock at 2/3 of intrinsic value, the price could go down further. There is a wonderful book, Money Game, written by “Adam Smith” which said, “Remember that when you buy a stock, it doesn’t know that you own it.” When Warren Buffett bought the Washington Post Company in the 1970’s, he believed he bought it at 40% of intrinsic value, yet the stock declined another 50%.
Buffett in a talk to Columbia business school students in 1993, said: “If you had asked anyone in the business what their properties (Washington Post Company) were worth, they’d have said $400 million or something like that. You could have an auction in the middle of the Atlantic Ocean at two in the morning, and you have people to show up and bid for that much for them. And it was being run by honest and able people who had a significant part of their net worth in the business. It was ungodly safe. It wouldn’t have bothered me to put my whole net worth into it. Not in the least.”
By 1973, the beginning of the severe 1973-74 stock market slump, Post Company stock had dropped from its original $6.50 issue price to $4.00 per share, adjusted for later stock splits. Buffett struck, buying his $10.6 million of Post stock, a 12% stake of the Class B stock at or about 10% of the total stock. The $4 price implied a value of about $80 million evaluation of the whole company, which was debt free at a time when Buffett figured the enterprise had an intrinsic worth of $400 million. Yet it was not until 1981 that the market capitalization was $400 million.
Regression to the Mean