What is the central point of investing? There are many ways to formulate an answer to this question, but I think a good starting point is that when you invest, you put money into something today in the hope that you will get more money in the future. Behind this simple answer lies many levels of complexity. For starters, where will the money be coming from? From the sale of the enterprise to someone else, or from within the business itself? Let’s dig into these questions.
Investing vs. speculation
This distinction of where you expect the money to come from strikes at the heart of the difference between value investing and speculation. Warren Buffett (Trades, Portfolio) is, of course, a committed value investor (although according to him, the "value" qualifier is unnecessary - all investing is by definition value investing).
According to Buffett, anyone who buys a business and expects to make a profit by selling it at a higher price is not investing - they are speculating. This is because such a strategy relies upon the existence of buyers who are willing to pay more for an asset than the initial investor, and this cannot be known ahead of time.
Why a business is like a bond
How is value investing different? To a value investor, a business is like a bond with an unknown coupon. By this, I mean that value investors try to estimate what the future cash flows of a business will be, given information that can be gathered in the here and now from financial reports and on the basis of ascribing an intrinsic value to that company.
In theory, it is possible to estimate the "coupons" of almost any business. However, in practice, it is very difficult to estimate future cash flows. This can be especially difficult in rapidly-growing companies or changing industries. For this reason, value investors generally deal with "boring" businesses such as utilities, consumer goods and telecommunications, where it is possible to more accurately forecast cash flows.
When Buffett and Charlie Munger (Trades, Portfolio) bought See’s Candies in 1972, they weren’t interested in what the business would be valued at 12 months from the purchase date. They wanted to own it for the cash that it was producing, not because they were going to flip it to another buyer. Of course, it’s not as easy as all that. Figuring out which companies are going to consistently produce cash is the hard part, as Buffett remarked at the 1997 Berkshire Hathaway annual investor conference:
“There are very few businesses that we’ll find where we’re certain of the future, and therefore we want companies where the certainty gets close to that and then we’ll want to figure of whether that’s a better buy than buying more of [stock in already partially-owned businesses]”.
Such an approach is consistent with Benjamin Graham’s philosophy of treating stocks as part ownerships of businesses rather than as simply pieces of paper whose prices fluctuate daily. By buying cash-generative businesses for the long haul, value investors give themselves the luxury of being able to sit back and look at the broader picture and not be distracted by the day-to-day ups and downs of the stock market.
Disclosure: The author owns no stocks mentioned.
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Read more here:
- Charlie Munger: Be a Generalist in a World of Specialists
- Warren Buffett: Writing Will Make You a Better Investor
- Bruce Berkowitz: Two Factors That Investors Should Consider
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