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Simplicity and Focusing on the Big Picture

August 11, 2007
gurufocus

Peter Lindmark

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"Our life is frittered away by detail... simplify, simplify." Henry Thoreau

Einstein listed the five ascending levels of intellect as: “Smart, Intelligent, Brilliant, Genius, Simple." Investors are detailed oriented and most never get to simple. Analysts have hundred page spreadsheets and focus intently on miniscule details, which are irrelevant over three to five year periods. Most investors miss the big picture due to their overly analytical minds.

“Keep the big picture in mind.” Joel Greenblatt

Thortnon O’glove wrote a terrific book, Quality of Earnings. The book helps the reader understand the nuances of financial statements. The theme is to spot blow ups and fraud by companies before an investor is affected by it. In an interview Thortnon O’glove stated, “I looked at the footnotes but they are not the big picture. Don’t lose the perspective of the big picture. Listen, I lost the big picture.” When an author and analyst is as adept as Thortnon O’glove is, at spotting these errors in the forest of information on companies, states that he lost sight of the big picture, we should all heed notice. Greenblatt has taken Mr. O’glove’s advice and has written the book The Magic Formula. In it Greenblatt focuses solely on enterprise value to earnings before interest and taxes and return on invested capital. These two numbers and the future of these two numbers are what Greenblatt wants to figure out before he invests.

Mohnish Pabrai has compounded money at 29% annually for eight years in his investment partnership. He recently stated in an interview with the Motley Fool that “Usually two to three variables control most of the outcome. The rest is noise. If you can handicap how those key variables are approximately likely to play out, then you have a basis to do something.” This is such a simple idea but investors do not apply it in their endeavors. Every company has key variables and as Mohnish so eloquently put it “If I find myself reaching for Excel, it is a very strong sign to take a pass.” If one cannot figure out the key variables, look at a different company, do not stray outside one’s circle of competence.

“There are an infinite number of facts that you can learn about a company, but there are usually two or three very important variables that make the company succeed or fail. A lot of Wall Street gets so bogged down in the minutiae and details that it misses these two or three big things that make or break the investment. Part of what worked for me over the years is being able to distinguish what matters from what doesn’t. That’s one of Buffett’s great gifts. He focuses on the critical issues involved in analyzing. I don’t pretend to be able to do it like he does but it’s one of the most important things you can do.” – Wallace Weitz

When Buffett looked at Coca-Cola he was probably looking at the total servings sold per annum and the profit per serving of each Coke. Those are Coke’s key variables, the number of servings people consume and the profit per serving for Coke products. Buffett was certain that consumption would increase through taking share of other liquids consumed. As well, he figured they could squeeze more than a penny per serving, which they were earning out of the product over time. Order as many analysts reports as you like from a broker and this information will be there but is very difficult to find in the sea of information they inundate investors with.

Bill Gates is another genius in simplicity through focusing on the key variables. At Microsoft, Mr. Gates focused solely on the revenue from each PC that Microsoft received. All Gates was trying to do in his days at Microsoft was to try to increase this number; all of the other figures are tied to this number and would take care of itself. When analyzing companies investors need to be able to break down their investments into the key variables for the company they are analyzing and then handicap the future results of those key variables.

Warren Buffett advocates writing down your thesis on paper. The thesis should be simple and short, no more than a paragraph. He prescribes an example in a 1991 lecture at Notre Dame, “I’m paying $32 billion today for the Coca Cola Company because… if you can’t answer that question, you shouldn’t buy it. If you can answer that question, and you do it a few times, you’ll make a lot of money.” Writing out one’s thesis on paper promotes rationality and gives one a concrete reason for why an investment was made. Our memories are limited and skewed towards the bias of recent information and having something to refer back to is helpful to avoid biases. When an investor can formulate a simple thesis and handicap the key variables into the future, they have found a potential investment.

“Things that are approximate and probabilistic don't lend themselves too well to Excel modeling. For me, the thesis ought to be painfully simple in your head.” – Mohnish Pabrai

Once an investor has compiled a simplistic thesis based on a company’s key variables the company should be a no-brainer, as Charles Munger refers to them. A no-brainer is when the situation is so obvious that you will make money. An example is when Mr. Buffett bought twenty securities in South Korea for an average of three times earnings. Mohnish Pabrai discards investments where he needs to run an excel spreadsheet. Charles Munger has quipped multiple times that though Buffett talks about discounted cash flow valuations he has never seen him actually do one. If it is so close that you have to do the calculus on a DCF the investment simply should not be made. It should be painfully obvious that an investment is undervalued based on its key variables if one is to purchase it.

Investors should follow the prescriptions of Einstein, Buffett, Gates, and Pabrai in simplifying, identifying the key variables, writing out your thesis, and investing when the situations are no-brainers!

About the author:

Peter Lindmark
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.0/5 (52 votes)

Comments

billytickets
Billytickets - 7 years ago
i enjoyed it peter.well done
recortes
Recortes - 7 years ago
Hi,

with all due respect to Buffet, Gates, Pabrai and the author of the article. I find hilarious to put the name of Einstein in the same statement.
buffetteer17
Buffetteer17 premium member - 7 years ago
I always put together an Excel DCF model (except for banks) when I'm considering starting a new position. Maybe Buffett and Pabrai don't do this explicitly, but I'll bet they do it in their heads at least. Buffett at least is a walking, talking spreadsheet program.

This little exercise takes me about 5 minutes, after having put together a template and done it hundreds of times. It is a very simple and crude spreadsheet: 9.5% discount rate, estimated current net assets, free cash per share estimates for 10-15 years, and a terminal value estimate. The hard part is coming up with the fcf/share data, which is of course my feeble attempt to predict the future many years out.

The result of this exercise is a fair value price. Naturally, it is highly uncertain. In most cases it tells me nothing..the band of uncertainty includes the current market price. Once in a while, the band of uncertainty is far above the current market price, in which case I become very interested in learning more about the company.

One can extrapolate from P/E ratios and probable growth rates 95% of the time, and get a decent fair value estimate. As Buffett says, in most cases, amortization equals maintenance capex. But I want to detect the cases where the simple P/E extrapolation fails miserably to capture real value. Those cases are often the deep discount diamonds in the rough. For example, CRYP lost 30% of their revenue in an instant last Fall, and their SG&A is taking a while to adjust. So their P/E and earnings are so unrepresentative of the future they should just be completely ignored for a year or so. But the DCF calculation can still be done, and it indicates that the fair value is around twice the current market price. Maybe guys like Pabrai can see this without the DCF model, but I need it.
vooch
Vooch - 7 years ago
Peter,

Great article, again!

- Vooch

ndl11
Ndl11 - 7 years ago
great article!

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